29th Annual Risk Management Conference Fundamentals of ... · Fundamentals of Options Part I March...

Fundamentals of Options

Part I March 3, 2013 Tim Weithers, Co-Director of Education, Chicago Trading Company

Jim Bittman, Senior Instructor, The Options Institute at CBOE

29th Annual Risk Management Conference

CBOE OPTIONS INSTITUTE 2

Disclaimer 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 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 involve multiple commission charges. Investors should consult their tax advisor about any

potential tax consequences.

The information in this presentation, including any strategies discussed, 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.

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. CBOE® and Chicago

Board Options Exchange® are registered trademarks and SPX, The Options Institute and Weeklys are

service marks of Chicago Board Options Exchange, Incorporated (CBOE). S&P® and S&P 500® are

registered trademarks of Standard & Poor's Financial Services, LLC and have been licensed for use

by CBOE.

Copyright © 2013 CBOE. All rights reserved.

http://www.theocc.com/


Session Outline

Why Options? Why Bother?

Brief Review of Basics

Understanding Strategies and Objectives

Performance of Benchmark Indexes

Introduction to Option Price Behavior


Why Options? Why Bother?

Without options,

there are three strategy choices.

Short Stock T-Bill Long Stock


Options Give You Options!

Ratio Call Spread Call Volatility Spread Split-strike Synthetic Put Volatility Spread

Long Straddle Short Straddle Long Strangle Short Strangle

Long Call Short Call Long Put Short Put

Options offer many strategy choices.


Possible Portfolio Objectives

Generate income

Limit risk

Reduce variability of returns

Lower the cost of protection

Creative portfolio protection

Tactical market entry and exit


Possible Uses of Options

Passive Strategies

(rules based and consistent)

Actively Managed Strategies

(subjective and opportunistic)


WHAT ARE OPTIONS?

Options are _________

Option buyers get ______

Option sellers get __________

WHAT ARE FUTURES?

Futures are _________

Futures buyers get ______

Futures sellers get __________

contracts

rights

obligations

Options Basics

contracts

obligations

obligations


Contract Terms

Buyers of calls get the __________

Sellers of calls get the _______________

Buyers of puts get the __________

Sellers of puts get the _______________

right to buy

obligation to buy

right to sell

obligation to sell

Why “buy the right”?

Why “assume the obligation”?

Why not just buy/sell the stock?


The action (also “Sell”)

Creates a new position

(Close to eliminate an existing position)

# of contracts

Underlying stock (100 shares) or index

Expiration month (3rd Friday)

Strike price or exercise price

Option type (also Put)

Price per share ($670 per contract)

Buy to Open 1 XYZ Dec 55 Call @ 6.70 Buy

Open

1

XYZ

Dec

55

Call

6.70

Options Require More Decisions


What are most options users doing?

What is a “strategy”?

Basic Option Strategies

Objectives:

Options are typically not used in a vacuum.

Generating Returns -- Profit Driven Managing Risk -- Risk Averse Containing Costs -- Premium Resistant


Premise: Long Stock (or Portfolio)

This is good.

This is not good.


LONG PUT

Bearish

Protect a stock/portfolio

SHORT PUT

Collect premium

(income)

Establish a buy price

LONG CALL

Bullish

Buy stock and limit risk

SHORT CALL

Collect premium

(income)

Establish a selling price

Basic Strategies at Expiration


#1 Protective Put

#2 Covered Call (or Buy-Write or Overwrite)

#3 Collar Variations

Common Option Strategies


Given a long underlying position:

Protective Put

advantage: absolute downside protection below the exercise price

disadvantage: reduces potential profit by the amount of the premium

X


X

What is a Protective Put?


Protective Put

Profit potential - Yes

Eliminates downside risk - Yes

At what cost?

Does make sense if used “tactically.”


advantage: premium received partially offsets downside loss

disadvantage: upside profit potential is now limited

X


Covered Call


What is a Covered Call ?

X


Covered Call

Profit potential – Yes (but limited beyond a point)

Eliminates downside risk – Not really

At what cost? – You actually take in money

(an income or “yield enhancement” strategy)

The most popular option strategy in equities

Typically used over and over and over again:

“strategically”


buy a Protective Put

sell a Covered Call


Collar


What is a Collar ?

Put Strike

Call Strike


Collar

Profit potential – Yes (but limited)

Downside protection – Yes (below strike of put)

Premium payment necessary – Maybe

Also, can be employed “strategically”

(though the strike prices may change)


What if you wanted “better” protection?

Old Put Strike

Old Call Strike

New Put Strike

New Call Strike


Variations: Protective Put Spread

exercise price

exercise price


Variations: Unbalanced Collar

Put Strike

Call Strike

Buy puts on 100%

Sell calls on 70%


Option Investment Strategies Summary

What exposures do you want?

What exposures would you like to mitigate?

What is your market view?

Where is the market going?

Where is the market not going?

When will the move happen?

Always remember: insurance is expensive when the house is on fire.


Benchmark Indexes

Three Passive Strategies

Writing covered calls on an index portfolio

Write at-the-money index calls

(BXM Index)

Write 2% out-of-the-money index calls

(BXY Index)

Writing cash-secured index puts

(PUT Index)


Writing Covered Calls

X

Call Expires

Keep Premium

Call I-T-M

Limited Profit

Own an S&P 500 Portfolio

Sell S&P 500 Index Call Options


Writing Cash-Secured Puts

X

Put I-T-M

Effectively Long

Put Expires

Limited Profit

Have cash (or cash-like investments)

Sell S&P 500 Index Put Options


Indexes Since Mid-1988

www.cboe.com/benchmarks Past performance is not a guarantee of future results

http://www.cboe.com/benchmarks


Benchmark Indexes

www.cboe.com/benchmarks Past performance is not a guarantee of future results

http://www.cboe.com/benchmarks


Excerpt from Jan. 2012 paper by Asset Consulting Group –

An Analysis of Index Option Writing for Liquid Enhanced Risk-Adjusted Returns


“Collaring” a Portfolio (CLL Index)

X

Put I-T-M

Limited Loss

Call I-T-M

Limited Profit

Have cash (or cash-like investments)

Sell S&P 500 Index Put Options

X

Options

Expire

Long

Portfolio


10

20

30

40

50

1000

1100

1200

1300

1400

1500

SPX

VIX

CBOE Volatility Index (VIX) vs SPX

S&P 500

VIX Index


Creative Insurance

Buy calls on VIX

• Allocate 1% of portfolio over 12 months to

purchase O-O-M VIX calls based on rules.

• The rules dictate the amount of calls

purchased based on the level of volatility.

VXTH is an index of this approach created

by CBOE.


Excerpted from paper by Asset Consulting Group -

“Key Tools for Hedging and Tail Risk Management”

(February 2012)


VXTH with VIX Call Weighting

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

0.00

20.00

40.00

60.00

80.00

100.00

120.00

140.00

160.00

180.00

3/3

1/2

006

7/1

1/2

006

10/1

7/2

006

1/2

9/2

007

5/8

/200

7

8/1

5/2

007

11/2

1/2

007

3/4

/200

8

6/1

1/2

008

9/1

8/2

008

12/2

6/2

008

4/7

/200

9

7/1

6/2

009

10/2

2/2

009

2/2

/201

0

5/1

2/2

010

8/1

9/2

010

11/2

6/2

010

3/8

/201

1

6/1

5/2

011

9/2

2/2

011

12/3

0/2

011

4/1

1/2

012

7/1

9/2

012

10/2

5/2

012

2/7

/201

3

Source: CBOE and Bloomberg

VXTH and S&P 500 Total Return Indexes (Through February 14, 2013, Scaled to 100 on 3/31/06)

VIX Call Weight S&P 500 (TR) VXTH Index


Excerpted from paper by Asset Consulting Group -

“Key Tools for Hedging and Tail Risk Management”

(February 2012)


New Topic: Option Pricing

Prior to expiration, an option’s price can

be estimated from six inputs:

Price of the underlying (stock price)

Exercise price of the option

Time to expiration

Current interest rates

Dividends paid during option’s life

Expected volatility of the underlying

over the life of the option

These are known

This is unknown


Impact of Underlying Price

Today Today

Stock Price 50.00 51.00

Days to Exp. 60 60

50 Call 2.50 ??

55 Call 0.80 ??

Concept:

3.00

Option prices change less in dollars than stock prices.

“Delta”

1.05

+ 2%

+20%

+31%


60 Days 40 Days 20 Days EXP

Stock Price 50 50 50 50

Days to Exp. 60 40 20 0

50 Call 2.50 2.00 1.40 0

−20% −30% −100%

55 Call 0.80 0.50 0.15 0

−38% −70% −100%

Concept:

Impact of Time

Different options decay at different rates

“Theta”


spot price

time

What is volatility?


Three meanings of “Volatility”

Historical volatility is the standard deviation of

returns over a prior time period (e.g. the last 30

days, 50 days, etc.).

Implied volatility is the volatility “in the market

price” of an option (e.g. if used in an option-

pricing formula, it will produce the market price

of an option.).

Realized volatility is the volatility experienced

by the underlying asset during option’s life.


Why Volatility is Important

Small changes in volatility can have a noticeable

impact on an option’s price.

Implied volatility can react very quickly to new

information, which causes option prices to adjust.

Typically, implied volatility rises when stock prices

are falling, and falls when stock prices are rising,

i.e., volatility and changes in underlying price are

negatively correlated.


0

25

50

75

100

125

150

175

200

225

250

275

300

325

350

375

-10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10% 12%

nu

mb

er

of

occ

urr

en

ce

s

daily price change (nearest 1/4 percent)

SPX Daily Price Changes: January 2003 - February 2013

number of days: 2546

biggest up move: +11.58% (13 October 2008)

biggest down move: -9.03% (15 October 2008)

mean: +.0300%

standard deviation: 1.31%

volatility: 20.77%

skewness: -.0544

kurtosis: +10.4475


100

120 call

90 days to

expiration

.25 each day + –

1.50 each day + –

10.00 each day + –

value =.05

value =.75

value = 8.00

option value

80 put


What We Expect

Stock Price

Strike Price

Time

Interest Rates

Dividends

Volatility

65 Call Price

→ 65

→ 33

→ 3.50

62

65

35 days

3.0%

0.0%

42%

2.10


What Sometimes Happens

A decrease in volatility can offset your expected gain!

Stock Price

Strike Price

Time

Interest Rates

Dividends

Volatility

65 Call Price

62

65

35 days

3.0%

0.0%

42%

2.10

→ 65

→ 33

→ 32%

→ 2.10


Option Pricing Concepts

Options prices change differently than stock prices.

Delta concept: options prices change less in dollars

than stock prices.

Theta concept: the time value of options decreases

over time, and different options decay at different

rates.

Volatility: (1) volatility can have a big impact on

options prices, (2) volatility changes, and (3) there

are different ways of thinking about volatility:

historical, implied, realized.


Using Options Requires…..

Understanding the trade-offs

Realistic expectations about option prices

Matching strategies to objectives


Options Are Not a “Zero-Sum Game”

Investors have different objectives.

Some want insurance.

Some want income.

Some want leverage.

Options offer all investors more

strategy alternatives.

Options Give You Options!

CBOE

400 South LaSalle Street

Chicago, Illinois 60605

www.cboe.com

Tim Weithers

[email protected]

312-863-8034

Jim Bittman

[email protected]

312-786-7491

mailto:[email protected]

mailto:[email protected]

29th Annual Risk Management Conference Fundamentals of ... · Fundamentals of Options Part I March...

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