Options 101

Effective Trading Strategies for Investors and

Speculators

First, a little story…

Recently, I had been speaking with an amateur trader who was considering taking a course, but was trying to justify the cost. Weeks passed without a word from him when I received his phone call. He was distraught and his voice was shaking.

“What happened?” I asked. He was slow to respond.

“I’m too embarrassed to say.” he finally said. The tone of his voice was enough to tell me what had happened.

To make a long story short, he had lost almost all his life savings (about 40K in total) by buying a large quantity of at-the-money call options a few days before a much anticipated earnings release on a volatile stock (one which was having some problems). His only research had come from an online chat group.

First, a little story…

Had this individual read through this short course on options and heeded its message, he would not have lost his savings (and possibly his marriage). And that is part of the reason why we are offering this, and other entry level courses in trading and finance for free. We want you to prosper with us. At the very least, we would hope that you avoid taking bad advice from charlatans.

We can’t promise that any course will ever make you rich, and we can’t prevent people from doing foolish things, as some people simply should not be speculating.

However, for those who are able to discern truth and recognize worthy knowledge, we offer this introductory course in options, gratis.

As always, “Caveat emptor.”

With more and more players in the trading arena, and the evolution of automated technologies which identify and execute

trading strategies, success in trading options requires an ever greater level of knowledge, experience and dedication.

In this introductory course intended for novice and intermediate investors, you will gain a foundational and practical understanding

of how to trade options, including new ways of understanding volatility and liquidity. You will also learn trading strategies which will help improve portfolio performance, or hedge your current

portfolio in stocks and futures.

The Options Market Today

This course is not intended for sale; it is offered for free as an introduction to our advanced courses in Options, Volatility, Risk

Management, and Trading System Development.

Online Finance Academy offers tailored trader training programs to both institutions and retail clients.

To further develop your understanding, and improve your portfolio performance, feel free to contact us for a personal

consultation.

info@onlinefinanceacademy.com

Course Contents

1) Introduction

2) Understanding the rudiments and theory

3) Volatility and time decay

4) Beyond the Basics I: Concepts in Hedging and Leverage

5) Beyond the Basics II: Hedging and Asset Acquisition

6) Part III: Options Strategies and Risk Management

7) Part IV: Contango and Backwardation

8) Part V: Understanding Volatility and VIX

9) Part VI: Implementing Your Strategy

An Options Analogy

• Let’s say you are a collector want to purchase an expensive ($2500) and rare guitar (which is no longer being made), but you don’t have the money.

• You ask the store owner to hold onto it for you for a few months until you get the money. He tells you that you need to put down a $100 non-refundable deposit to hold onto it for you (guaranteeing that you won’t have to pay more than $2500 for it.)

• You ask if the deposit is deductible from the price of the guitar. He says no: the total cost will be $2500 plus the $100 deposit.

• Why you would you agree to this? He reminds you that the price of this guitar keeps going up because the company closed down and will never open again. So you pay the $100.

An Options Analogy

Scenario 1.

• 3 months later you come back to buy the guitar and you notice there are several guitars identical to the one you optioned and they are selling for $1500. Suddenly, you have no incentive to buy the guitar for $2500.

• Why did the price go down? The store owner explains that the company is back in business and it’s no longer a collector’s item. Suddenly, you are no longer interested. You don’t buy the guitar. You lose the $100 and don’t exercise your option to purchase the guitar (but you save $900 had you bought it 3 months before).

An Options Analogy

Scenario 2

• 3 months later you come back and notice the price has gone up to $3500. You tell the owner hey, why is the price up? I have an option to buy it at $2500.

• He says: “Oh yeah”...and has a sad look on his face because you have a legally binding agreement. He must sell you the guitar for $2500.

• You just made yourself $1000 minus the cost of the option. (profit = $900)

An Options Analogy

• When you paid the owner $100 to buy the guitar in the future at a pre-determined price, you bought a call option with an exercise price of $2500.

• When you purchased the guitar you exercised your option.

• When you refused to buy the guitar you let the option expire worthless.

A more concrete example:

IBM Example:

IBM common stocks trades at $140

A 16 March 140 call gives the investor the opportunity to buy the stock up until the expiration date (March 2016) at $140

Options are given expiry dates as follows:

Every week for the following 2 months, then one more month, then every 3 months.

Example: 11 Dec, 18 Dec, 24 Dec, 31 Dec, 8 Jan, 15 Jan, 22 Jan, 19 Feb, 20 May

More Formal Definitions

• An option is a derivative asset whose value declines to zero over a certain period of time. (the guitar was the asset, the option to buy it was the derivative)

• Options give firms and speculators flexibility in making investment decisions and planning for the future.

• They give speculators opportunity and the ability to limit risks. The flip side of this is that they can alsoreduce your opportunity and increase your risk. This is the trade-off you make when you deal in options.

Back to our Options Analogy

• In our analogy, the store owner had reduced his opportunity by selling you the option. His reward was what we call ‘premium.’

• You, however, had increased your opportunity but paid a premium for that right to purchase in the future at a specific price. You limited your risk to the downside by buying the option, the price you paid for this right was your premium.

• We often refer to this as buying premium or selling premium. Buying premium means you are speculating;

• Selling premium means you are hedging: they are both side of the same coin.

2. Understanding the Rudiments and Theory

Critical Terminology

• Call: the opportunity to buy an underlying instrument in the future;

• Put: the opportunity to sell an underlying instrument in the future;

• Premium: the price of opportunity on future movements in the stock price.

• Naked Option Writer: selling a call or put without owning the underlying asset (risky)

• Covered Call: owning the underlying and selling a call option that allows you to generate income from selling the opportunity for future gains (conservative)

Calls and Puts Applied

The buyer of a call option has the right but not the obligation to purchase a pre-specified amount of a pre-specified asset at a pre-specified price during a pre-specified time period.

The seller of a call option has the obligation to sell a pre-specified amount of a pre-specified asset at a pre-specified price if asked to do so during a pre-specified time period.

The buyer of a put option has the right but not the obligation to sell a pre-specified amount of a pre-specified asset at a pre-specified price during a pre-specified time period.

The seller of a put option has the obligation to purchase a pre-specified amount of a pre-specified asset at a pre-specified price if asked to do so during a pre-specified time period.

Options and Options Markets Terminology

European Options

European options can be exercised only on the maturity date.

American Options

American options can be exercised any time prior to maturity.

Intrinsic Value

The value of an option if it is exercised immediately. (stock price minus strike price) This is the portion that is ‘in the money.’ Also related to the term: ‘selling off the stock.

Option Clearing Corporation (OCC)

Oversees the conduct of the market and helps to make the market orderly. If an option is exercised, the OCC matches buyers and sellers, and manages the completion of the exercise process.

Puts Explained

• A put is not the opposite side of a call option.

• In our analogy, if the store owner thought that the guitar factory would come back into business and the price of the guitar would come down, he might consider buying a put (selling you the obligation to buy the guitar at $2500)

• If you had sold him a put option, the store owner would be smiling because you would be legally obligated to buy the guitar from him at $2500 even thought the price was $1500.

Naked Explained

• Let’s say the store owner did not actually own the guitar but promised you he could get it for you and you agree to the contract to buy it from him at $2500 and the price actually goes up to $3500. He would be unhappy because he had written a naked call option and that option was exercised by you.

• If you had written a naked put option at $2500 (and made some premium for selling him the right to sell you the guitar, it would mean you were obligated to buy the guitar from him at $2500, regardless of what price it was in the future.

• Writing naked options means you are uncovered. It is risky, and requires extra margin in your account because writing naked options always obligates you.

• In the Money (ITM) (current price is $3500, strike price is $2500) – the call option would be ITM because the current price is above the strike. It has intrinsic value.

• Out of the Money (OTM) (current price is $1500, strike price is $2500.) It has no intrinsic value, only time value (the chance that the price will go up before the option expires)

• At the Money (ATM) Strike price and current price are equal. ATM options have the most liquidity and most accurately reflect current market sentiment.

More Formal Definitions

• Long: means you bought an asset.

• Short: means you sold an asset.

• So, if you are long puts it means you have bought the opportunity to sell the underlying asset at a certain price in the future. (You think the market is going down).

• Contrarily, if you are short puts it means you think the market is going up.

• So…if you sold puts naked,…it means you are so bullish that you sold someone the opportunity to buy an asset that you don’t own.

More Formal Definitions

An Example of Selling a Put

• A Put gives you the right to sell an asset at a particular price in the future. So…

• If it is September and XYZ Corp stock is trading at $31 and you think the stock is likely to go down to $25 within the next 3 months, you should consider buying a December 30 put. Let’s say the cost of this option is $2.50

• Dec 30 is the date of expiration and strike price.

• $1 is the intrinsic value (difference between strike and current price)

• Time value is $1.50 ($2.50 - $1.00)

The importance of Strike Price

• If the current price is $31 and the strike price is $30 the option for the 30 strike is going to cost you significantly more than an option with a strike price at $26. (due to the improbability of price declining that far.)

• There is significantly more % profit with a strike price that is far out of the money but significantly less chance that the price will go below $26.

• We are always looking for the ideal trade-off between risk and return, “the sweet spot.”

How do we find that sweet spot?

The Sweet Spot in Options Pricing

• The ideal profit target / stop loss should be at a ratio of 3 to 1; the ideal ratio for options is similar.

• Scenario: It is Sept. The Dec XYZ 10 call is priced at $1.

• The current stock price is $9.50,

• If you buy the call, In 3 months the stock will have to go above $11 in order to break even: $10 + 1 = net cost.

• $.50 / $1.50 (difference between breakeven and current time premium)

• Rule: We are seeking a trade with a high probability of moving a certain amount within that period of time. Buying far out of the money calls or puts is in general, akin to gambling. In the lng run it doesn’t work. Don’t do it

The Sweet Spot: Case Study

• BNS Current price: 58.95, Dec 5

• Mar 60 call: Current average price: $1.65

• Mar 64 call: Current average price: $0.43

• $60.00 + $1.65 = $61.65: $61.65 – $58.95 = $2.70 (breakeven)

• Net profit = $1.65/$2.70 = approx 3/5 ratio

• $64.00 + $0.43 = $64.43: $64.00 – $58.95 = $5.15 (breakeven price)

• $0.43 / $5.15 = approx 1/12 ratio

• So, considering this, we should probably buy the 62 calls. However, considering that Bank stocks have very low betas (not volatile) we should buy the Mar 60 calls and even consider selling the 64 calls. (This is known as a bull call spread; to be discussed later)

3. Volatility and Time Decay

Pricing Options: in briefWhat would cause the price of an option to go up or down?

The obvious:

• i) Price of the underlying asset: theoretically, options prices should move proportionate to the underlying asset price...although this isn’t always true... Why? What could cause them to not be in sync?

• ii) Volatility: if the asset hasn’t moved much in the past it is unlikely to move much in the future…so it deserves a lower price. (i.e., bank stocks different from orange juice futures!)

• iii) Time to expiration: greater chance of an asset moving more over a longer time period. More time = more chance that the market will move in your favour.

More Key Factors in pricing options

The less obvious:

• i) Liquidity and volume: the further the strike price is from the current price, the less liquidity and volume there is. Very difficult to get accurate pricing if there are a lack of traders. This is very relevant and not regarded by the Black Scholesoption pricing models.

• ii) Proximity to Strike Price: if current price is deep in the money it will trade off of intrinsic value. (like buying the stock but with more leverage)

• iii) Opportunity Cost (risk free rate of interest): not so relevant.

Value in options

Therefore,... the most valuable option is one which:

• Has a lot of time to expiration; • is in the money;• has some volatility in the underlying asset;• Is highly liquid.

Therefore, as a general rule, we should…

• buy long term options which are liquid.• sell options which have less time to expiry

(We will discuss volatility and proximity to strike later.)

Reviewing Basics...

• Describe what a call option is...

• Describe what a put option is...

• Premium: The income you receive when you write an option.

• Naked: selling a call or put without owning the underlying asset (risky)

• Strike Price: The price at which an option will be redeemed into the underlying asset on expiration day

About Calls

• When you buy a call (speculative): an opportunity to buy the underlying asset in the future;

• When you sell a covered call (conservative): limits your opportunity for future gains because you are selling someone the right to buy your asset in the future. However, you do recover a premium.

• When you sell a naked call (speculative): maximizes your risk to the upside by collecting a small premium.

About Puts

• Buying puts (speculative) gives you an opportunity o do something in the future.

• Selling puts (also speculative) obliges you to buy something in the future. If the price drops to or below the strike price on or near expiration day you will likely be ‘called’ (have to buy the asset).

• So our basic strategies are as follows...

Basic Strategies with calls and puts

• When we think something is going up (significantly) in the future, we buy a call.

• If we think the price is going down, we buy a put.

• If we think price is going down slightly but will likely be mostly flat, we may write a call

• If we think price is going up slightly but will likely be mostly flat, we may write a put.

• If we think something is going down and there is no chance of going up (!) (we may consider selling a naked call …or writing a spread…more about that later)

4. Beyond the Basics I

Concepts in Hedging and Leverage

Options can be used in several distinct ways:

• Hedging an existing position in stocks, futures etc.

• Creating a regular income from the sale of risk premium.

• Using them for leverage when you lack the capital to buy the underlying security.

• Using them to acquire an asset at below current market price.

Hedging a position in stocks, futures etc.

• If you are a producer of corn (for example) there are 2 ways you can hedge your production: sell a futures contract, or sell a call option on a futures contract and / or but a put on a futures contract.

• The difference? Selling a futures contract is a simple commitment. However, with options, the counterparty may or may not take delivery.

• Example...If you produced a million bushels of corn and bought puts on it, you may be protected on the downside, but the cost of the option minus the profit on the downward move will be less than if you had just sold the futures.

Why people would hedge with options

Let’s say you own a lot of stock but don’t want to sell it

• i) you want to collect the dividend or...

• ii) you own so much you believe selling it would influence the price downward)

• iii) you are very unsure of future price direction

• By selling a call option far OTM you collect a small premium but will profit a bit if the stock goes up.

• Selling far ITM is almost the same as selling the stock (high premium collected but high chance of being called)

• Selling ATM: if the stock falls you are not going to be called, but at least you collected a premium.

What is the ideal strategy?

Hedging with Options• Ideally, we are looking for a stock that pays a strong

dividend, is expected to stay flat but has periodic volatility and which we don’t mind holding.

• Example: (if you are Already long)

• Over a 1-2 month span you notice the stock can easily move 10 percent. Look for a spike near the top of that longer term range to sell call options (ATM).

• Trade needs to be made on strong momentum (you are contra-trend) to ensure you capture the volatility premium. Otherwise little premium captured.

Why not just buy a put?

• i) You don’t know the stock is going down! (This strategy works best in flat markets with periodic volatility.)

• ii) Buying a put means paying a premium which comes to about 5% per month for a stock like BNS.

• iii) If you can continue to sell calls every 2 months, you can generate about 30% a year assuming the stock does not move. It comes down to probability.

• What you risk is holding a stock going down precipitously or any upward move in the stock.

Who hedges and why?

• Options structure does not suit commodity producers; simpler to just sell production for future delivery.

• Options are ideal vehicles for banks (structured products) and speculators and funds looking to hedge portfolios without affecting the market price of the underlying asset.

• Long term investors with a diversified portfolio with both short and long positions. You need many covered call positions like this to have a smooth profit curve.

Creating a regular Income from Writing Premium

• This Strategy relies on the concept of time decay (theta).

• In the long term there is lots of opportunity for an asset to fluctuate. People are willing to pay a lot for this opportunity.

• In the short term, esp. over about 4 to 6 this time premium declines rapidly.

• So the general idea is to be selling an option just before this premium starts to decline rapidly. (our sweet spot is around 45 days to expiry.)

Using Options for Leverage

• Many new options traders are attracted by the idea of the massive leverage afforded by buying OTM calls or puts.

• The rules of probability tell us that over the long term, this is a losing strategy.

• Why? Typical options premiums are around 5% per month. (60% per year) How many stocks move up 60% a year or in a straight line? Probability is not on your side.

• Purchasing far OTM options is a gamble against time and unknown market forces. Trading exclusively on sentiment puts you at a disadvantage.

So what to do?

• In general, buy in the money options with a long duration.

• Allows you massive leverage depending on how far ITM you are.

• You can’t be too far ITM because liquidity dries up the further OTMyou are and if you need to get out of a trade you might not be able.

• Strategy: you use must trade with longer term momentum (because this is the same as trading highly leveraged stock: the value of the option is mostly intrinsic.)

• Positive Intrinsic Value / trading off the stock: If we have a option with a strike of $20 and the stock is trading at $25, the option has $5 of intrinsic value.

Leveraged Option Trading

• Strategy continued:

• If you are in a profit: 2 main ways to manage your trade:

• i) Sell a shorter duration call against your long position (you are ‘covered’ by the longer term call.)

• ii) Sell the option outright

• If you have a loss: If the momentum is counter to your position and there is less than 2-3 months duration, you must get out.

• Key rule: Salvage what you can. At least half of your trades will be losers. The trick is to limit your losses on any option to no more than 50% of the initial price.

Acquiring an Asset at below Market Price

• Long term investment strategy: Better than if you were going to buy the asset .

• This strategy is employed by many fund managers to acquire a stock for their portfolio.

• It allows them to make a small income from writing put premium

• Main risks: if stock goes below strike price you are obligated to purchase at some point in the future. This is potentially catastrophic for some stocks (bad earnings, bankruptcy etc.)

• On indexes, it’s a far better strategy

5. Beyond Basics II:

Focus on Volatility

Options and Volatility

• Introduction to Volatility and Liquidity

• The Option Pricing Model

• Overview of Options Strategies

• Calendar Spreads up-close

• Volatility and the VIX (contango effect)

• Volatility Strategies

• Further Study on Volatility (implied and historical)

Introduction to Volatility and Liquidity

What causes Volatility? It’s caused by...

• Crises which cause create an environment of uncertainty.

• A lack of liquidity: fewer players in the market means exacerbation of stress response and wider spreads (nobody willing to take opposite side of trade).

• Key point and opportunity: unlike prices, volatility always reverts to the mean.

Psychological Component

• People may know that over a long enough time horizon volatility and prices will revert to the mean.

• So, expectation that chance events will occur and seizing them is key.

• So, when trading options, we need to wait for premiums to expand dramatically before making our trade. It is not the same strategy of longer term stock or commodity investing (i.e., scaling into a winning position)

Options Pricing Models

• Intuitive Approach

• Black Scholes

• The Greeks

• Liquidity Analysis

Intuitive Approach to pricing Options

Intuitively, you can price options by asking basic question:

1) how far are we from the expiry date

2) how accurate is the pricing (determined by proximity to strike price and volume)

3) The trend of the underlying asset

4) Volatility...which affects people’s perception of how far the asset is capable of moving. Depends on the asset class and endogenous variables.

What Affects Option Prices: Black Scholes

Five factors affect the price of options on stocks without cash dividends:

Factor Name Call Option

Put Option

S Stock Price + - E Exercise Price - + T Time + + σ Volatility of Underline Stock (Standard Deviation) + + r Risk-Free Interest Rates + -

The Value of Put Options and Put-Call Parity

Using our prior calculations, what would be the effect of a 1% change in stock prices? What are the speculating opportunities?

Original Values 1% Increase 1% Decrease

S = $100 S = $101 S = $99

C = $11.84 C = $12.73 C$10.95

Options can be used to take very low risk speculative positions by using options in combinations. The combinations are virtually endless, including combinations called strips, straps, spreads and straddles.

The Value of Put Options and Put-Call Parity

For example, suppose a stock is trading for $100 per share.

Using the Black-Scholes OPM, we have computed the value of a call option with a $100 striking price to be $11.84. The interest rate is 12%. The value of the put option is computed as:

$1.13 = $11.84 + $100 - (1.12)

$100 = P

Black Scholes Model:

• Forget about fancy calculations (Black Scholes) and strategies such as Iron Condors and Butterflies etc...The Black ScholesModel does not include the effect of liquidity on asset values...and this is key

• When you begin trading options the spread between bid and ask is critical. If you need to get out of a trade quickly you won’t have efficient market pricing.

• Market pricing is only efficient in a stable market at the money.

Trading with liquidity on your side

• The decline in value of implied volatility and the greeks is why it is usually the best policy to sell premium on momentum. This is because volatiltiy reverts to mean. This is opposite to what you should be doing with stocks (following momentum)

• The reason for this is that there are usually many buyers willing to trade with increasing momentum (easier for you to get a good price). This increased liquidity means you can easily find a buyer willing to pay a good price. With declining momentum and a near term expiry the option value will decrease far more in percentage terms than an ITM option.

• Therefore, sell the options on a stock that is rising quickly toward a strike price (assuming you are long the stock).

The Greeks

• Vega measures the sensitivity to the underlying instrument's volatility. (easy to understand and so not too important)

• Delta measures sensitivity of the option price to the underlying asset’s price. (important)

• Gamma measures the sensitivity of delta in response to price changes in the underlying instrument.

• Theta measures the time decay of the option. (important)

What does all this mean and what do we really need to know?

Vega

• Vega (Volatility) – Measures the change in the value of the option price, based on a change in volatility of the underlying.

• We know that a longer period of time allows more opportunity or chaos to occur. Therefore, it affects price significantly. The more time remaining to option expiration, the higher the vega.

• Thus, vega may increase due to an increase in volatility, even if the option is approaching expiration

Delta

• Delta is the amount an option price is expected to move based on a $1 change in the underlying asset.

As an ITM call option nears expiration, it will approach a delta of 1.00, and as an ITM put option nears expiration, it will approach a delta of -1.00. (this terminology is not so important). Delta is a very important concept to appreciate for strategy development. We know where delta is going to increase rapidly

• Delta is fairly predictable and constant but will also vary according to the type of product we are trading

• Our goal is to buy as delta at it is increasing (approaching the strike price) and sell as it is decreasing (as it goes further ITM)

Gamma and Theta

• Gamma is generally is at its peak value when the stock price is near the strike price of the option and decreases as the option goes deeper into or out of the money. (There is little you need to understand here…theoretical)

• Options that are very deeply into or out of the money have gamma values close to 0.

• Theta is a very important concept to understand for any kind of Option writing strategy. (We will discuss this in much greater depth later.)

The Critical Role of Volatility

Historical (statistical) Volatility: stocks that have had large price swings in the past will have high levels of Historical Volatility.

- Measured over the previous 30 trading days- Measured by calculating the standard dev. of daily price changes- HV does not affect the price of an option!

Implied Volatility- An estimate of the potential volatility over the next 30 days. - an increase in IV will increase option price (and vice versa)

Historical Volatility

• Historical Volatility will give some guide to how volatile a stock is, but that is no way to predict future volatility. The best we can do is estimate it (Implied Volatility) This range of volatility affects the demand for options contracts at particular prices.

• At the money (ATM) options have the most liquidity and are least affected by volatility caused by a lack of liquidity.

• ** ATM options are the most accurate in terms of valuation... Therefore, if we find ourselves in a need to cover a position (prevent possible loss) we should always be looking at buying/selling an option at or near the money. **

Implied Volatility

Implied Volatility takes into account any events that are known to be occurring during the lifetime of the option that may have a significant impact on the price of the underlying stock: i.e., earnings announcements, the release of drug trial results for a pharmaceutical company.

The current state of the general market is also incorporated in Implied Volatility. If markets are calm, volatility estimates are low, but during times of market stress volatility estimates will be raised. One very simple way to keep an eye on the general market levels of volatility is to monitor the VIX Index.

Implied Volatility-up close

• Volatility tends to revert to the mean, whereas price doesn’t. So,

• When IV is peaking and expected to drop, we should be selling options,

• When it is at a low and expected to rise, we should be buying options.

Strategy:• Buy options only when historical volatility and implied are

low: (in a range, no news announcements expected etc...)

• Sell Options after the news or after a price spike. Price is always rich on increasing momentum (need to fade) (remember, buy on mystery, sell on history)

Volatility Smile

• Theoretically, Implied Volatility increases the further out of the money you are. It forms a smile shape with the ATM being the lowest IV.

• The volatility smile pattern is common in near-term equities.

• Why near term? Less chance that anything major will happen so there is little premium, little reason for the market to be biased toward the short side or long side.

Volatility Skew

• Volatility skew often appears for longer term equity options and index options. The skew pattern shows that in-the-money calls and out-of-the-money puts are more expensive compared to out-of-the-money calls and in-the-money puts.

• Why? Markets over the long term tend to rise, but crash periodically. (This skew did not appear in options prices until after the crash of 87)

• Also, ITM calls offer leverage. (therefore, greater demands for ITM calls.

Volatility and Gamma

• Gamma indicates how the delta of an option will change relative to a 1 point move in the underlying asset. In other words, the Gamma shows the option delta's sensitivity to market price changes.

• In other words, Gamma shows how volatile an option is relative to movements in the underlying asset.

Gamma / strike price

Vega and Implied Volatility

• IV = expected volatility in the underlying asset. This accurately reflects the time value of the option

• Vega = an option’s sensitivity to implied volatility.

• Vega measures (theoretically) how much the price of the It measures the theoretical price change for every percentage point change in volatility.

• As we approach the strike price, vega will be sensitive to IV.

• As it touches the strike price vega is = to IV. As the option goes ITM, it declines

Vega changes / strike price

Key Points to remember

• Gamma, Vega, Delta...they all are sensitive the closer we get to a strike price.

• We need to go long calls or puts in anticipation of this strike price being touched.

• We need to short calls or short puts in anticipation that this strike price will not be revisited.

• For example: if we sell a put option at a strike of $10, our ideal entry point is at-the-money.

Volatility in options: causes

- 1) Illiquidity: when strike prices are far from the current market price (and when close to expiration) the spread between the bid/ask rises significantly. People not willing to pay the spread unless desperate.

- Spread generally benefits the option seller. Anyone buying at market would pay a massive spread /hard to get of position.

2) Volatility tends to rise when equity markets fall

Volatility provides diversification and de-correlation

Long term negative correlation: -0.70 (if market is declining expect the volatility index to follow it at about a 70% correlation)

Liquidity: a key but overlooked parameter.

• When no buyers or sellers at a particular price level, it is next to impossible to get out of a bad position at a reasonable price when the market goes against you. This is the rationale behind…

• i) Selling far OTM calls and puts (post spike)

(After a rapid price spike in your favour) chance of retracement after a spike and a rapid decay of theta. If you needed to cover at market your price would be reasonable.

• ii) Buying ITM puts and calls

(When you expect a rapid price move) for leverage. The market will move according to intrinsic value.

How a rapid price move affects illiquid and far ITM / OTM call options

• March 18 expiry, FSLR current price 64.75(up $5 today)

• March 45 call $20.93 (+ $9.93)

• March 50 call $16.47 (+ $4.67)

• March 55 call $12 (+ $3.05)

• Mar 62.5 call $7.46 (+ $2.5)

• March 75 call $2.58 (+ $1.04)

• Mar 80 call (B $.94 /A $3.10) (no trades)

How a rapid price move affects illiquid and far ITM / OTM put options

• March 18 expiry, FSLR current price 64.75(up $5 today)

• Mar 50 put $.69 -2.18 no trades)

• Mar 55 put $1.38 (- $1.38)

• Mar 62.5 put $5.00 (- $6.10)

• Mar 65 put $6.69 (- $3.06)

• Mar 70 put $9.50 (- $3.60)

Volatility Premium in options: causes

- Implied volatility is higher on Put than calls (which explains the negative correlation) as markets have a tendency to build slowly and collapse.

- This distortion reflects downside risk & demand to hedge “tail risk”. This distortion is persistent on all equity indices constantly in time. Premiums on puts is generally higher. Selling puts will pay you more for selling premium to account for the risk.

- Premiums on Calls also reflects the possibility of ‘takeover’. Therefor, stocks that were offered to be bought out but were refused permission or declined will have a lower call premium than more obvious takeover candidates.

6. Part III

Option Strategies and

Risk Management

Strategies Taking Advantage of Illiquidity: concept checking questions

• Is it better to sell near the money calls and puts or OTM calls and puts? Why?

• What are the risks with selling naked far OTM options?

• How can this risk be mitigated?

• If you are in a losing option position (i.e., you sold calls ATM and the market price is at least 5% above your strike price) is it better to buy the stock to cover yourself or buy back the calls? (2 ways to liquidate)

Hedging versus Liquidation

• Hedging is done when you still believe in the position but recognize short term risk. When do we hedge a losing position?

• Assume we went long a stock at a major support level: ABC at $10 a share. The stock declines to $9.50 the next day.

• Facts...

• OTM Call option premium (strikes above $10) will have declined significantly (proportionately).

• ITM Call premium (strikes below $9) has declined less.

• ITM Put premium (strike of $11) has increased

• Near OTM Put premium has increased proportionately more (delta increasing).

Strategy: Hedging or mitigating a loss

• It’s always better to liquidate the stock...! However, if you are bullish long term you can...

• Sell the stock outright and buy long term ITM call options on a further decline (ITM calls unlikely to decline as much as OTM calls) (more bullish)

• Buy ITM puts (buy the $10 strike or above)to protect against further decline. (less bullish)

• Remember, true hedging is done before an adverse price moves. These strategies are mildly bullish to neutral and intended to reduce risk over the short term.

Why Institutions Hedge

Hedging for extreme events (i.e., buying OTM puts) may be used to hedge against unknown risk. But,...it is costly compared with a simpler strategy of selling your stock.

So why would investment institutions buy puts?

- Because their market actions combined could bring down the price of the underlying asset.

- It is a useful tool to protect against specific event risk (e.g.. mergers and acquisitions, or to express a tactical view on market direction.)

Options Strategies and Logic

The above url will direct you to a CME paper on investment strategies using options. Look at some of the more complex strategies ( last half of the paper) and think about some of the questions on the following pages. Not all the best strategies are indicated in this pdf!

http://www.cmegroup.com/education/25_proven_strategies/CME-113_21brochure_SIDE_SR.pdf

Is it better to buy or sell options?

Call and put buyers are speculators and the passage of time is their enemy.

Covered sellers are hedgers or looking to generate income. The passage of time is their friend. You can’t fight the passage of time so in general, it is better to be a seller of premium.

The relationship between buyer and seller is like a casino versus the gambler: markets favour the house or the owner of capital (i.e., the person selling risk premium.)

Far OTM options are like lottery tickets.

Is it better to buy or sell options?

- As an owner of capital you can “write premium”...sell calls on long positions. (Note that selling puts on short positions is not the mirror opposite of selling covered calls).

As a speculator you need to time the market because you are fighting time and a lack of liquidity.

- Time is not on your side when you are long options. It becomes a case of luck. We don’t want to rely on luck or hunches. We need to rely on the math.

- The math (probability) tells us that over the long run it is better to sell risk. There are times when it makes sense to buy options, but these positions should be longer term.

Hedging and the impact of time

• There is a very rapid proportional decline in time premium between the 6th week to the expiration date.

• For long term options between 1 year and 2 years out, options only lose about 15-20% of their value in time premium.

• If we count up the time premium per month, it adds up to about 5% per month. This comes to about 60% per year.

• So, it makes sense to buy an asset that does not decline rapidly and selling the same asset that does decline.

Hedging and Calendar Spreads

• Thus, ideally, we want to sell options which are nearing expiration. If we can continue to do this indefinitely we can generate a regular source of income.

• Think of it this way....if we buy the 2 year expiry, we will experience very little decline in the value of the option (all else being equal). It may decline 20% over a year.

• We sell the options that are about between 1-2 months out and we see over a 5% decline in the value. If we do this repeatedly, every 2 months, we can generate an income in excess of the decline in value of our longer term option.

Calendar Spreads: taking advantage of time decay

• A long calendar spread would entail buying a longer term expiry and selling a nearer-expiration option of the same strike and type.

• Long calendar spreads are traded for a debit, meaning you pay to open the overall position. (The value of the long option is worth more than the short options…so you do this when you are bullish long term). This is what Metallgesellschaft did with oil as it was moving into backwardation during the Iraq war (and it killed the company)

• But in general..it’s a good strategy. They just messed up because they controlled over 35% of the market and there was a feedback when they tried to exit the market.

Calendar Spreads: taking advantage of time decay

• This strategy profits in a limited range around the strike used. The trade can be set up with a bullish, bearish or neutral bias.

• The greatest profit will come when the underlying is at the strike at expiration.

• Calendar spreads also profit from a rise in implied volatility after the options were purchased, since the long option has a higher vega than the short option.

• Vega (sensitivity to volatility)...

Implied volatility and time decay

• Options in nearer-month expirations have more time decay than later months (they have a higher theta).

• The calendar spread profits from this difference in decay rates.

• This trade is best used when implied volatility is low and when there is implied volatility "skew" between the months used, specifically when the near-month (the options you are selling) has a higher implied volatility than the later-month (the options you are buying).

Calendar Spreads: taking advantage of time decay

• Calendar spreads lose if the underlying moves too far in either direction. The maximum loss is the debit paid, up until the option you sold expires. After that, you are long an option and your further risk is the entire value of that option.

• Therefore, The ideal situation when placing a long calendar spread is when the market is relatively stable (say at a trough with support) and selling the nearer term option on short term bullish spikes (OTM)

• If only this was that easy to forecast! We need to know what to do when things don’t go as we would like or expect!

The Calendar Spread: same strike price

• When trading options, we still need to forecast the longer term direction of the market.

• Selling OTM or ATM calls in a declining market is straightforward : We go long the long term expiry and short the near term expiry.

BUT...

• In a rising market, we buy long term OTM or ATM puts, and we sell the near term puts.

• The strike price for both side of the position should be the same. If they are not, we incur extra risk.

Bull Calendar Spread (Calls)

• Buy long term slightly OTM calls and simultaneously

Selling an equal number of near month calls of the same underlying asset with the same strike price.

• Strategy is bullish for the long term and is selling the near month calls with the intention to ride the long term calls for free.

• Advantage and risks:

• Unlimited Upside Profit Potential: Once the near month options expire worthless, this strategy turns into a discounted long call strategy.

• The maximum possible loss is limited to the initial debit taken to put on the spread. This happens when the stock price goes down and stays down until expiration of the longer term call.

Example

• It is January 2016 and you believes that ABC (trading at $50) is going to rise gradually over the next year. You buy a Jan 2017 55 OTM call for $500 and write a Mar 55 OTM call for $200. The net investment required to put on the spread is a debit of $300.

• In March, The stock price of XYZ goes up to $53 and the Mar 45 call expires worthless. You can re-write a Jun 55 call for approx $200 and repeat the process. The idea is that the time decay on your long term position is less than the near term option.

• Risks: If the underlying does not rise you will have to make a decision…hold onto the long term option, sell it, or hedge it with another option… Here is how that would work.

Managing a loss

• Let’s say it’s February 2016 and the underlying is at $48. The value of the option you sold is almost worthless and the option you bought is declining. If you feel the market is going to decline much further you should sell it outright and buy a put.

• By buying a 55 Put (ITM) the stock is now trading off intrinsic value. Should the underlying reverse and go back up your OTM call will rise in value but not as much as the ITM put will lose value. Therefore, this is a risky (and not an ideal) strategy.

• Only do it as a momentum trade on a fast decline and ensure the put is ATM and between 3 - 12 months out (better liquidity for near term ATM options) but too much risk of a premium decline < 3 months.

Calendar Spread (bear call): same strike price

Example: ABC Corp is trading at $50. We buy a $50 call expiring in 2 years, and sell the $50 calls (expiring in 3 months).

Risks...If ABC declines significantly, our long option will decline (but not as much as if it were ITM or ATM)

Strategy... we do this when we expect the market to be flat to bullish over the 2 year time horizon but bearish over the next 3 months.

The Calendar Spread (bear call): different strike price

We buy the long term expiry (OTM) and short the near term expiry (ATM). Same scenario...but we incur risk between strike prices. This is done to reduce our margin commitment and when we have a strong belief the market will decline.

Example: ABC Corp is trading at $50. We buy a $55 call expiring in 2 years, and sell the $50 calls (expiring in 3 months).

Risks...If ABC declines significantly, our long option will decline (but not as much as if it were ITM or ATM)

Strategy... we do this when we expect the market to be flat to mildly bearish over the 2 year time horizon.

Calendar Spread (Bull Put): buy OTM / sell ITM

Example: ABC Corp is trading at $50. We buy a $45 put expiring in 2 years (because we don’t expect the stock to go down) and buy the $45 puts (expiring in 3 months) as protection in case it does .

Risks...If ABC declines below $50 (on expiry day), we will be obliged to buy the stock. If it declines significantly (i.e., below $45 we are protected against further decline.

Strategy... we do this when we expect the market to be bullish over the next 3 months. This is not an ideal strategy because the difference in premium between

The Calendar Spread: different strike price

• Calls: If we buy a long term ITM call and sell near term OTM calls we are in effect:

• Bullish the underlying for the long term, but expect a short term decline. If price of asset goes down...

• Risks: a loss or profit equivalent to the underlying / we gain only a little premium (proportionately)

• If price of asset goes up...

• Significant profit on the option but unable to profit because near term option cancels out any profit...

• Therefore...not a good strategy!

Out of the money or in the money?

Buying out of the money options nearing expiration is the most speculative of all strategies because it offers the trader immense leverage.

This is the strategy to use when you know something is going to happen (i.e., buying Sep puts on American Airlines stock just before 9/11)

(No…someone with an offshore account in Switzerland just got very ‘lucky’ ;) )

Out of the money or in the money?

- You need a very good reason to be going long OTM. It is better to buy longer term ITM options (as a proxy for the stock) for their leverage over the stock and momentum trade it.

- Main disadvantage of buying far OTM or ITM options is the lack of liquidity. The spread increases and it is difficult to get a fill for an order.

- The greatest profits occur to someone long an option is when an option moves from OTM to ITM (trading off the stock) (change in delta)

Out of the money or in the money?

- Why does the option value change?

Because the option now also has intrinsic value while before it only had time value.

- Thus, choosing the correct strike price (around levels of magnetic attraction) needs to figure in our decision to buy or sell a particular option.

- Option sellers obviously want to sell outside this particular level of magnetic attraction. It makes less sense for them to sell an ITM call than it does to buy an ITM Put.

Market orders vs sitting on the bid or ask

- Illiquid markets are characterized by randomness and people being forced on occasion to take a market order.

- It is a good idea to have offers and bids reasonably far out of the money rather than trying to trade them intraday.

- The Markets which become quite volatile intra-day can result in a good fill.

- It is usually better to sell options

Calendar Spreads and the Sweet Spot• The sweet spot: We should look at positions where the net debit is

approximately 3 times the net credit. This balances our profit with out risk.

• For example, if you are paying $9 for an option contract and the net credit to you is $3, his is ideal from the perspective of potential return vs risk.

• If you are paying $10 for an option, and selling an option for $1, you would need to trade the option 10 times to recoup your risk. (This scenario occurs if you buy an option (ITM or ATM) but sell an option far OTM. )

• As one can see, the more bullish you are, the farther out the expiry on the option you sell.

• A more neutral strategy would have a net credit of less than 2 to 1.

Review Example: Bearish Calendar Spread: (longer term bearish short term neutral)

Buy GLD 17 Jun 2016 110 PUT $6.01(Gives you the right to sell the underlying shares at 110 upon expiration)

Sell GLD 17 Jul 2015 110 PUT $.77 or…

Sell GLD 17 Jul 2015 112 PUT $1.30

(Gives you the obligation to buy the underlying at the strike price).

If I get exercised on the 112 (price is at or below 112 on July 17) I am forced to buy the underlying at 112. The long option which I paid $6.01 for is my protection. It allows me to sell the underlying at $110. However, I received a credit of $1.30 so if the underlying is above 110.70 at expiration I have broken even or made money.

Time Decay and Rising Asset Prices

Jan 2017 VXX 19 calls $6

Jan 2017 VXX 25 calls $4.45 (comparison)

Jun 12, 2015 (12 days) VXX 19 Calls $0.56

June 26, 2015 (25 days) VXX 19 Calls $0.94

July 17, 2015 (45 days) VXX 19 Calls $1.41

Sep 15, 2015 (100 days) VXX 19 Calls $2.32

(Long the Jan 17, 19 calls at $6

(Short the July 15, 19 calls at $1.41)

As soon as this contract expires sell another 5 to 7 weeks out and continue the process indefinitely. This is an income generator

Time Decay and Declining Asset Prices

VXX Current price: $18.84

Long Jan 2017 VXX 19 Puts $6.50

Short (one of the following….)

July 17, 2015 VXX 18 Puts $1.01

July 17, 2015 VXX 17 Puts $0.54

July 17, 2015 VXX 16 Puts $0.25

The position may have a bearish bias but the strategy is not a good income generator.

A bad idea would be to buy protective calls against a short position in the underlying because as soon as volatility subsides the premium decay is extremely rapid

General Strategy Concepts: The Short Straddle

• Called a short straddle because you sell a call and a put at the same strike price. You are in effect ‘straddling’ the strike price because you are unsure which way the price will turn and you want to gain premium. You do this when you expect the price to remain stable .

• A true straddle is executed when the market price is equal to the strike price.

• If the strike is lower than the current market price you are in effect bearish and expecting a bounce because you are selling an ITM call (and expecting the value of this to change from intrinsic to time value only.)

• If the strike is higher than the current market price you are in effect bullish and expecting a retracement because you are selling an ITM put (and expecting the value of this to change from intrinsic to time value only.)

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General Strategy Concepts: The Long Straddle

• Called a short straddle because you buy a call and a put at the same strike price.

• You are in effect ‘straddling’ the strike price because you expect the market to move significantly in the short term but are unsure which way. You do this when you expect an earnings announcement etc…

• What to watch out for… that the premium you pay for each position is less than the expected move for the stock. Remember, over the long run markets tend to range and buying short term options is usually a losing strategy

General Strategy Concepts: Straddles

Q) In what circumstances would you do this strategy? What do you expect to happen?

Q) Does time decay work for you or against you?

Q) Considering this, how far out would you buy this straddle?

General Strategy Concepts: Straddles

Short straddle: sell a put and call at the same strike price (ideally at the current market price)

Q) If you choose this strategy what do you expect the market to do in the near future?

Q) Considering this, how is this not a good thing wrt the premiums you collect for selling these options.

Q) If this is the case, when should you attempt to execute such a strategy?

Q) How far out would you sell this straddle?

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General Strategy Concepts: The Short Spread

Strategy: You think market is going down but not that much so you...

- Buy 1 put

- Sell 1 put (further OTM) to recover some premium.

Q) Is this something you would do on an index or an individual stock, why?

Q) If the market price is closer to the price of the put that you bought, what is the effect of time decay (premium) for you?

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General Strategy Concepts: The Long Spread

Long spread: Probably the most popular trade because markets (stock) in general are usually going up and you can still collect premium.

Q) This may be popular but under what circumstances and what products would this trade not be as good as simply going long one call?

Q) How does this position compare to buying a stock and immediately selling OTM call options on it?

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The Butterfly Spread

Butterfly: Looks like a butterfly’s wings extended (like a straddle and a spread combined. )You do not expect the market to move much in either direction. (neutral strategy)

• A long call butterfly spread is a combination of a long call spread and a short call spread (max profit is at current price).

• The goal is for the OTM calls to expire worthless while capturing the intrinsic value of the in-the-money call with strike A.

Q) What advantages and disadvantages are there of buying (or selling) this spread instead of a straddle?

Q) What do you limit when you write a butterfly as opposed to a spread?

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The Set-up

Buy 1 call, strike price (ITM), has intrinsic value, risk is limited to initial outlay.Sell 2 calls, strike price (ATM) sensitive to changes in delta. Buy 1 call, strike price (OTM) to protect yourself against a extreme upward move.

• The cost of the OTM call will be significantly less than the ITM call…

• So…your break even points will be…- the cost of the ITM call minus the credits paid to you on the ATM calls;- the cost of the OTM call minus the credits you received.

The Butterfly Spread

• Advantages:

• Limited maximum loss

• Disadvantages: high commission costs may outweigh the benefits.

• Limited upside (only gain the premium)

• Very complicated and difficult to find the correct options with adequate liquidity (if you buy this spread at the market you will likely get the worst possible price)

The Short Strangle

• Sell 1 ITM Call, Sell 1 OTM Put

• Called a Strangle because the profile resembles a neck line. This is like a straddle but with two contracts sold outside the money. (Risk non extreme moves in either direction);

• Maximum profit occurs when the at expiry is trading between the strike prices of the options sold. Both options expire worthless and you keep the entire initial credit.

• Advantages: Usually a good likelyhood that prices will remain within a range in the short term.

• Disadvantages: Risk of loss is unlimited

General Strategy Concepts: The Short Strangle

Q) When would you want to do this?

Q) What markets in recent history would have worked well using a strangle strategy?

Q) What are the risks of a strangle and how can you hedge against this this risk?

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‘Synthetic’ Stock Strategies

• Used to simulate the payoff of going long or short a stock without using the capital that you would normally require.

Synthetic short:

Buy 1 ATM CallSell 1 ATM Put

Synthetic Long :

Buy 1 ATM PutSell 1 ATM Call

Synthetic short stock

Concept checking questions...

• What if we are only slightly bullish and we think that the market has found a base support but has a small chance of rising significantly...

• What would you do to optimize this opportunity?

• What combination of options?

Changing our Strategies...

A) Synthetic short: Buy 1 ATM CallSell 1 ATM Put

B) Synthetic Long :Buy 1 ATM PutSell 1 ATM Call

i) How would you modify these strategies if you were not that bearish (A) or bullish (B)? ii) What if you were more bearish or bullish? iii) What about selling OTM calls and buying OTM Puts?This is in effect a composite of a strangle and a bear call spread. You might do this when you are mildly bearish (as you aren’t risking much capital)

Part 4: Comprehensive Review and Options Rationale

7. Part IV

Contango and Backwardation

Volatility: Contango and Backwardation

The Challenge: Profiting (or not losing) from changes in volatility. Can we actually predict changes in volatility? To some degree yes.

We know volatility is short-lived and things revert to the mean.

In general, any strategy that sells premium for slightly ITM options at volatile times can take advantage of volatility decay and time decay.

Theta Decay ( time decay)

The reason short calendar spreads work (sell the long term, buy the near term) is because they take advantage of time decay…

Notice from the next two diagrams how selling options between the 30 to 60 day mark is the “sweet spot”.

If you can hang on for two weeks by selling contra-trend at a critical level (expecting mean reversion) you will find your self in a profitable short trade where time decay rises exponentially. This is great if you sold premium OTM

Delta (proportionate change)

• Delta means ‘change’ in Greek. In this case it refers to the assymetrical change in the value of an option when it moves from being OTM to ITM.

• Ex: Consider a call option with a strike price of $20. If the stock moves from $19.50 to $20.50 in one day, the value of the option will move more proportionately than if the stock had moved from $18.50 to $19.50, or from $20.50 to $21.50. The logic is this...

A speculation has now become an investment!

VIX and Volatility (and the contango effect)

8. Part V

Understanding Volatility and VIX

VIX and Volatility

• Volatility is the foundation of options pricing and risk assessment. If we can quantify potential changes in volatility we can determine better stops and profit targets

• People spend an inordinate amount of time on assessing price trends compared to risk and volatility.

• In that absence of attention we can find opportunity. This is why we need top look at VIX

• Remember...equity markets may have skewed valuations and trend indefinitely, but VIX is a mean reverting asset

VIX Calculation (not that interesting but worth knowing)

VIX is interpreted as annualized implied volatility of a hypotheticaloption on S&P500 with 30 days to expiration, based on the pricesof near-term S&P500 options traded on CBOE.

Contrary to what many people believe, the VIX is not calculatedusing Black-Scholes or any other option pricing model.

There is a formula which directly derives variance from the wholeset of prices of options with the same time to expiration. Twodifferent variances for two different times to expiration are theninterpolated or extrapolated to get 30-day variance. This variance isthen transformed into standard deviation (by taking the squareroot) and multiplied by 100. (you don’t need to know this! )

VIX Calculation Step by Step: (only if you’re really

curious)

1) Select the options to be included in the VIX calculation.

2) Calculate each option’s contribution to the total variance of its expiration month.

3) Calculate the total variance for the first month and the second month.

4) Calculate 30-day variance by interpolating or extrapolating the two variances, depending on the time to expiration of each.

5) Take the square root to get volatility as a standard deviation.

6) Multiply the volatility (standard deviation) by 100.

The result is VIX.

Liquid VIX ETFs, ETNs and indexes:

The following VIX ETFs and ETNs have average daily volume at least in hundreds of thousands of shares; some of them in millions; VXX in tens of millions.

VXX = iPath S&P 500 VIX Short-Term Futures ETN

UVXY = ProShares Ultra VIX Short-Term Futures ETF

XIV = VelocityShares Inverse VIX Short-Term ETN

TVIX = VelocityShares Daily 2x VIX Short-Term ETN

VIXY = ProShares VIX Short-Term Futures ETF

SVXY = ProShares Short VIX Short-Term Futures ETF

VXZ = iPath S&P 500 VIX Mid-Term Futures ETN

VIIX = VelocityShares VIX Short-Term ETN

• There are other volatility indexes besides the VIX. For the big indexes, you have VXN for the Nasdaq, RVX for the Russell, and VXD for the Dow Jones.

• http://www.cboe.com/micro/volatility/introduction.aspx

VIX: the ``commodity’’ of equity markets

• Why? It’s pricing is determined by the supply and demand of options on the S&P index. It can be traded as a futures contract or as an option on a futures contract. There are several trading products related to VIX; these include products volatility indexes on commodities, currency futures, global indexes etc.

• These volatility products are used to hedge against such price declines and to some degree help mitigate the risk of a plunging market because their uses reduces the requirement to exit the underlying asset outright.

• Fund managers have a mandate to be invested in the market. In order to protect their positions against declines they need to purchase puts.

• http://www.cboe.com/micro/volatility/introduction.aspx

VIX: a gauge of fear and complacency

• If markets look like they are going to sell off, investors are going to buy protective puts. Because options exist as contracts and not some tangible product, the supply of a put or call is only based on the demand (and vice versa). The VIX measures this change in premium between calls and puts.

• This change in premium accurately measures the degree to which traders are willing to take a risk.

• It comes down to supply and demand. Nobody is willing to sell puts in a rapidly declining market, but when the equities market looks like it will bounce, new people will come in and VIX will trough. (Trading VIX is a momentum strategy, not something you invest in or fade.)

Calculating VIX

• To calculate the VIX, there is a weighting factor which makes the value of the closer options more significant.

• VIX calculation also looks at the "near term" options that have more than 7 days to expiration, as well as "next term" options that are the month after that.

• Instead of looking at the extrinsic value of a single option, a weighted average of the total premium in the market is taken and a standard deviation is derived from that. This is done for the whole market (puts and calls.)

Calculating VIX

• When investors buy options, the implied volatility rises, and that in turn raises the value of the VIX.

• Does the VIX lead the SP?

• Sometimes the options market will lead the underlying market, in part because options markets are less liquid. At other times the options market is reactionary as players rush to buy protection after the down move already happens.

• The correlation between the VIX and the SPX is about -0.8. That means it is not a perfect inverse relationship, and there are times in which the VIX diverges from movements in the SPX.

• Divergences between normal correlations between VIX and stocks indicates traders are positioning for a market change.

Comparing the VIX • By comparing two different volatility readings, you can get a feel for

the relative risk premium in separate markets.

• For example, if you compare the RVX to the VIX, you'll see how much premium people are buying in Russell options compared to the S&P. The premium in the Russell because these represent smaller cap stocks which are more risky.

• When this ratio gets too low, it indicates complacency in the market, and when it gets too high, a good amount of fear.

• Another great timing indicator is to compare the VIX to the VXV (3 month volatility readings). Because we know more about near term risk compared to market risk 3 months from now, the VIX tends to be lower than the VXV.

VIX and Mean Reversion

• Given the nature of fear and options, the VIX will stay towards the low end of the range for a while, and when market participants are fearful, the VIX will spike up but will not sustain at those levels.

• There are a few instances in which the market has a complete dislocation of risk, both higher and lower. It's very difficult and nuanced to figure out if a spike in the VIX will calm down or if this move is "the big one.“

• VIX futures don't track the spot VIX on a 1:1 basis.

• That's because the VIX futures are guessing where the VIX will be at a certain date, not where the VIX is right now. This is what we call a "forward" contract.

VIX: the ``commodity’’ of equity markets

- VIX Futures = Futures contracts with monthly expirations settling on spot VIX.

- VIX is generally in contango (like index option volatility)

- In a trending market, option volatility is higher for longer maturities unless the market is very stressed. (compare this to treasury market...more risk in long dated maturities.)

During heightened market volatility , traders “bid up’’ near term volatility producing Backwardation in the VIX futures.

- This volatility is “stored’’ in SPX options and variance contracts, but is not easily converted to VIX and vice versa.

Why it’s a bad idea to invest in VXX.

Every month the VXX suffers from negative roll yield when the CBOE VIX futures curve is in contango. The VXX ETF must “roll” its futures to rebalance to the later contract and as the expiration date nears, it is forced to sell its closest to expiry contracts and buy the next dated contracts. The purchases are often at higher prices if the curve is in contango, thus losing the spread amount between the two contracts that are rebalancing.

Between its inception 2009-01-29 to the end of 2015, the VXX is down close to 99% while the VIX is only down 65% over the same time period.

The next question regarding this anomaly is how can a trader possibly benefit from this? Avoid buying the VIX! At least do not hold it beyond a period of 1 to 3 days (max).

The effect of contango on VIX: possible strategies

• If you expect a decline in volatility and/or a rise in the general stock market, short the VXX ETF knowing that the prescribed “decay” affect will work in your favour 75% of the time.

• Simply shorting VXX or writing bearish call spreads and calendar spreads can take advantage of this.

• Example…if you sell calls on the VXX you can take advantage of this time decay. You may need to use a spread if your account does not allow writing naked calls.

• Better than shorting the VXX outright since in an extreme market move you can find yourself scrambling to cover your losing position

Volatility Strategies

Options traders are interested in how volatile a stock is likely to be during the duration of a trade. Stocks that have had large price swings in the past will have high levels of Historical Volatility. This is the key reason for higher options premiums on some stocks compared to others.

The key question we need to ask is whether this historical volatility is likely to continue into the future. This is where some knowledge of technical analysis can be very useful.

Historical Volatility will give some guide to how volatile a stock is, but that is no way to predict future volatility. The best we can do is estimate it (Implied Volatility)

Implied Volatility

Implied Volatility takes into account any events that are known to be occurring during the lifetime of the option that may have a significant impact on the price of the underlying stock: i.e., earnings announcements, the release of drug trial results for a pharmaceutical company.

The current state of the general market is also incorporated in Implied Vol. If markets are calm, volatility estimates are low, but during times of market stress volatility estimates will be raised.

One very simple way to keep an eye on the general market levels of volatility is to monitor the VIX Index.

Volatility and Skew

Options markets are not normally distributed between puts and calls. There is a skew toward puts due to the tendency of the markets to collapse with more acceleration than they rise.

This distortion reflects downside risk & demand to hedge “tail risk”. This distortion is persistent on all equity indices constantly in time. Hedging for extreme events (i.e., buying OTM puts)is in general costly compared with a simpler strategy of switching out of equities.

It is a useful tool to protect against specific event risk (e.g.. Mergers and acquisitions or insurance buyouts), or to express a tactical view on equity markets.

The VXX and VXZ ETNs

• VXX: iShares ETN which tracks short term VIX futures (months 1 and 2) target maturity 30 days; continuous roll

• VXZ: iShares ETN, tracks mid-term VIX futures (months 4 through 7); target maturity 120 days; continuous roll

• Both securities are correlated to the same underlying asset.

• Look at the following charts and notice how this contangoeffect (of VXX based on short maturities and rollover) kills the value of VXX over time.

• VXZ (in red) VXX (in orange)

Look at the next chart...

• What product is likely to be increasing as the market is falling quickly...

• VXZ (in red) rollover every 4 months and therefore less prone to contango effect and recalibration or...

• Or VXX in orange (rollover every month and recalibrated every month)

What happened in the first 2 weeks of October 2014?

Why the anomaly from the general tendency?

Why was VXX actually stronger?

S&P was in a freefall. It is not often that markets decline like this without a retracement.

But eventually, everything comes back to the mean (if that’s not too presumptuous)

So,…what’s the strategy?

Consider that volatility has a strong general tendency to revert to the mean over time.

Buying VXX (and holding on for more than a few days) is a losing strategy.

Buying VXZ as a hedging instrument (buy and hold) is better than hedging with the VXX. Still, time has proven it is also a losing strategy

It is better to buy the actual vix futures when ‘shit hits the fan’

So,…what’s the strategy?

Or...something a bit more complex...

Buy VXZ (the less volatile vix contract) as a very short term hedge (1 to 3 days)

but sell VXX after markets have declined significantly and momentum is just beginning to change. (premium will be at a spike high)

Explain why this might be a good strategy...

Why this strategy?

After an extreme move markets have a tendency to mirror or retrace the previous move.

The strategy buys volatility when it is low (as a hedge for a longer term position) and sells volatility (VXX) when it is high as a speculative position.

We are taking advantage of the disparity between VXZ and VXX. VXX always loses its value faster than VXZ when the S&P is rising.

In general, it is a good idea to short VXX at the periodic rapid declines in the S&P (which is counter-trend) but historically has proven to be the correct strategy.

Conclusions

- Commodity ETFs based on futures underperform the underlying VIX futures contract

- The VXX, VXZ ETNs are subject to contango effects.

- Options on VXX and other ETNs still remain interesting, as they can be structured to monetize the dynamics of the slope of the futures curve.

i.e., imagine writing premium on VXX!

Is Volatility Mean Reverting?

The answer is yes, volatility does revert to its mean. This is true for both realized and implied volatility, which are of course closely related.

In general, volatility (in this case the VIX index) is:

- Trending (and often quite well) intraday

- Having fast spikes up on market crashes, followed by gradual decline back down

- Staying in the same value range in the very long term

Backwardation

Backwardation means that forward contracts are priced lower than nearer term contracts, or spot, and when it occurs it is a sign of (current runaway prices) and price deflation to come.

As an example, suppose you could buy gold today (Dec. 2015) for $1150/oz, and suppose the June 2015 contract was priced at $1130/oz.

One of the most memorable times when the gold market was in a backwardation was during the Iran Hostage crisis and people were bidding up gold over 100% in a matter of several months.

Backwardation

That means gold today is worth more than what the futures market says it is going to be worth in the future.

(This is usually not the case...markets are traditionally in a contango)

Backwardation happens due to momentary supply shortages in a spot market for “soft” commodities, especially natural gas or oil.

Further Study

Easy Volatility Investing, Tony Cooperhttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=2255327

In order to create a long term volatility trading strategy for inclusion into an investment portfolio we need to consider the following...

1) Stock market volatility, unlike returns, is predictable

2) Changes in volatility are negatively correlated with changes in market prices

3) Investors are prepared to pay us a premium (the Volatility Risk Premium) for us to take volatility risk off their hands

9. Part VI

Implementing your Strategy

The most conservative strategies include:

• ITM covered calls (not much point in doing these...often better to just sell the asset.)

• OTM / ATM covered calls: The further out the less risk/reward. Need to focus on sweet spot

• Calendar spreads: Can be among the most effective, requires more ‘mathy’ thinking and technical analysis etc.

ITM Covered Calls

• Strategy: Find an industry that you expect to be going down with no prospect of rising over the course of your option.

• Better to sell ETFs or companies which have no chance of being taken over! Lest you miss out on any massive upside move.

• By selling ITM, you will only potentially gain in the intrinsic value of the stock. It is the equivalent of selling the stock outright. You will not gain from time expiration since time value is primarily a function of delta.

• Why do it? You may want to collect the dividend, you may be trading them for swing trades (using max leverage)

OTM Covered Calls

• Strategy: Find an industry that you expect to be flat to slightly down with no really strong prospects of being strong in the long term. However, you still want to hold the stock for some particular reason.

• Better to sell ETFs or companies which have no chance of being taken over!

• By selling ITM, you will only potentially gain in the intrinsic value of the stock. It is the equivalent of selling the stock outright. You will not gain from time expiration since time value is primarily a function of delta.

• Why do it? You may want to collect the dividend, you may be trading them for swing trades (using max leverage)

• You should sell calls on temporary spikes up but coinciding within the longer term trend.

• This allows you to sell on increased premium(taking advantage of volatility premium)

• Option pricing does not pay attention to technical analysis and support /resistance levels, so you need to sell at around a particular support level . The market may rest around such a level for but a few days.

• If price is there longer you know the resistance is more likely to break and therefore should get out of your option by...

• i) buying it back,

• ii) buying a call option in the money to initiate a spread

• iii) buying a call OTM to initiate a call spread

Selling uncovered calls

Example

• Gold and Oil from 2014 on had no real prospect going up but had several short covering spikes.

• During these spikes within the channel the price would quickly go from OTM to in the money for many gold etf and gold stock options.

The idea is to...

• Sell when they are near the money or just ITM to take advantage of delta decline. If / when the options go down (made more likely by the channel), selling short term options allows us to take advantage of theta decay.

Calendar Spreads

The Call Calendar Spread.

• Current market Prognosis: neutral to bullish with little expectation of a strong extended move upward.

• Set this strategy by: buying long term calls and simultaneously writing an equal number of near-month ATM or slightly OTM calls of the same underlying asset with the same strike price.

You are selling time (theta)

• You expect the price to remain unchanged at expiration of the near month options so that they expire worthless.

• The options trader can then either own the longer term calls for less or write some more calls and repeat the process.

What can happen as a result...

• This is the same strategy that Metallgesellseschaft had used on a substantial amount of oil futures during the Iraq war. It bankrupted them.

• As the price of oil briefly entered a backwardation, the company found itself with a massive amount short of ‘near expiry’ calls, while they had been long the longer term expiries.

• Rule, never ever do this on a commodity that can enter a backwardation! (best on stocks and ETFS)

Will this work the other way around?• Possible Strategy: Buy long term, OTM puts (opportunity to

sell far into the future at a distant strike price) and sell short term puts:

• Logic: doesn’t make much sense to buy a far out of the money put. We need protection on the upside, not downside!

• Possible Strategy: Buy long term puts at the same strike price as those that you sell.

• If price goes down further than what you sold at you are completely protected. This is strictly a trade that takes advantage of theta. You do this when you expect a retracement over a longer term downtrend.

• Need to sell when volatility is high

Will this work the other way around?

• Selling short term ATM puts makes us very vulnerable:

• We are obligated to buy the stock if in the short term it declines. This is likely to happen.

• Therefore, the strategy is to sell puts after market has declined substantially and rapidly:

• i) Selling ITM takes advantage mostly of possible delta change from ITN to OTM (as price bounces back up

• ii) Selling OTM takes advantage primarily of time decay.

• Theoretically, If we continue to do this every 3 mths, the cost of buying puts may be in excess of what we sold (opposite from previous strategy).

• So we would only do this if we thought the market was going to have repeated spikes down (Where we would buy an ATM options)

Final Words

You are ultimately responsible for your trading success or failure.

Successful Trading requires a calm, steady mind free of emotional distractions. It also requires knowledge, experience

and regular study of market conditions.

This course is not an offer to buy or sell securities and is only for informational purposes.

If you would like to pursue trading more seriously, contact us.

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