Financial Planning Association of Philadelphia Area

King of Prussia, PA (November 16, 2011)

Philip H. Gocke

1-888-OPTIONSwww.OptionsEducation.org

www.OptionsEducation.org/institutional

PGocke@theocc.com +215-667-9546

The Options Industry Council (OIC)

OIC was created as a non profit organization to increase awareness, knowledge and responsible usage of exchange -listed equity options. The OIC exchange -listed equity options. The OIC conducts seminars and webinars, distributes interactive CDs and brochures, and maintains a Web site and Help Desk focused on options education.

Our sponsors are….

1-888-OPTIONSwww.OptionsEducation.org

www.OptionsEducation.org/institutional

OIC: institutional member of FPA for 3 years

website for advisors: OptionsEducation.org/advisor

Bellomy Study: 48% of Wealth Managers with AUM of $500mm have used options at least once in past 12 m onths.

The Options Industry Council (OIC)

Three most popular advisor strategies:

1. Covered calls for yield enhancement1. Covered calls for yield enhancement

2. Stock insurance – protective puts

3. Calls & Puts together – collars

OICOICWhy Options?4

In a world without options,

stock investors have limited choices.

Long Stock Short Stock Treasury Bill

OICOICWhy Options? 5

With options, there are other choices:

Long Call Short Call Long Put Short Put Long Straddle Short Straddle

Long Strangle Short Strangle Long Call Spread

Long PutSpread

Short CallSpread

Short Put Spread

Ratio Call Spread

Ratio PutSpread

Long Split-Strike Synthetic

Call VolatilitySpread

Put VolatilitySpread

Collar

Options give you options!

OICOICOptions Are Tools6

• Options give you more ways to implement your market research.

• Options make it possible to target a variety of investment objectives:

° reduce risk

° increase income

° unique tradeoffs

Who Are The Parties In The Contract?

• Holder: Buyer (has a “long” position)- Options buyers have rights

• Long Calls: the right to buy

• Long Puts: the right to sell

• Writer: Seller (has a “short” position)- Options writers have obligations

• Short Calls: the obligation to sell

• Short Puts: the obligation to buy

Long StockPercentProfit or Loss

1086420

Profit

(Long Call)

2

Percent Change in Stock Price

0-2-4-6-8

-10-10 -8 -6 -4 -2 0 2 4 6 8 10

• Equivalent to two options (long call, short put)

Loss

(Short Put)

OICOICThe Call Buyer

Profit

0

+ UnlimitedProfit Potential

IncreasingLimited

–

IncreasingStock Price

Risk vs. reward for long call

° profit potential is unlimited° risk is limited to premium paid for option

Loss

LimitedRisk

Short StockPercentProfit or Loss

Profit

(Long Put)

1086420

4

Percent Change in Stock Price

0-2-4-6-8

-10-10 -8 -6 -4 -2 0 2 4 6 8 10

Loss

(Short Call)

Stock Price = $56.0050-strike Call Option Price = $8.00

Time Value = $2.00

Stock Price = 56

What Are You Paying For When You Buy An Options Contract?

Strike Price = 50

Option Premium (or

Price) = $8.00Intrinsic Value

= $6.00

Note: Intrinsic Value must be greater than or equal to zero.

Time Value = Total Premium – Intrinsic Value For a 60 Call at $2.10What is the intrinsic value?

What is the time value? $0

$2.10

OICOICThe Put Buyer37

Profit

0

+ SubstantialProfit Potential

IncreasingStock Price

Risk vs. reward for long put° profit potential is substantial

° risk is limited to premium paid for option

–Loss

LimitedRisk

Covered Call

Buy stock at $43.50, sell 45 Call at $2.30

5

+

Covered Call

5

40 45 50

Long stock at $43.50

0

–

Covered Call

OICOICProtective Put

Buy 100 shares ABC at $42.00Buy 60-day ABC 40 Put at $1.55

5

+Long stock 5

5

35 40 450

–

Break-even at Expiration:Stock Price + Premium Paid

$42.00 + $1.55 = $43.55

Maximum Loss: $355.00

Long stock at $42.00

BEP $43.55

OICOICOptions Pricing

Option Pricing Model

• Input

° stock price° strike price° strike price° volatility° time until expiration° cost of money (interest rates less dividends)

• Output

° call and put premiums (theoretical values)° the “Greeks”

OICLet’s simplify

OICOICStock Insurance

Automobile

Car PriceDeductible

Time

Stock

Stock PriceStrike Price

TimeTimeInterest RateDriver Risk

TimeCost of Money

Volatility

OICOICCar Insurance

$15,000,000

$500.00

6 Months

Driver A(safe driver)

Driver B(reckless driver)

Car Price

Deductible

Time

$15,000,000

$500.00

6 Months

Which driver would you rather insure?

6 Months

5%

Time

Interest Rate

6 Months

5%

$450.00 $650.00Premium

OICOICTime Decay

Option premium erodes with the passage of time• only time value affected – not intrinsic value

• erosion accelerates as expiration approaches

Cal

l Val

ue

3 2 1

Time to Expiration (Months)

Speed Bumps, Black Swans and Things that go Bump in the Night

OPTIONS STRATEGIES FOR RISK MANAGEMENT23

24

25

26

BIG Speed Bump

27

http://online.wsj.com/article/SB10001424052748703313304576132170181013248.html?mod=WSJ_WSJ_News_BlogsModule

Sam Zell

29

“I think you could see a 25 percent reduction in the standard of living in this country if the US dollar was no longer the world’s reserve longer the world’s reserve currency,” Sam Zell.

“That’s how valuable it is.”(Sam Zell on CNBC 3-3-11)

30

31

October Unemployment - 9%

Where do we go from here?

33

Debt ceiling debate: hurt reserve role of $$$

34

1.2500

1.3500

1.4500

1.5500

1.6500

1.7500

1.8500

CLO

SIN

G S

PO

T

Swiss Franc (daily closing)

35

0.7500

0.8500

0.9500

1.0500

1.1500

1.2500

11/1

9/92

06/2

5/93

01/2

6/94

08/2

9/94

04/0

3/95

11/0

3/95

06/1

0/96

01/1

3/97

08/1

5/97

03/2

3/98

10/2

3/98

05/2

8/99

12/2

9/99

08/0

1/00

03/0

7/01

10/0

9/01

05/1

3/02

12/1

3/02

07/1

8/03

02/2

3/04

09/2

7/04

05/0

2/05

12/0

2/05

07/1

1/06

02/1

4/07

09/1

9/07

04/2

4/08

11/2

6/08

07/0

2/09

02/0

5/10

09/1

3/10

04/1

5/11

SF

-CLO

SIN

G S

PO

T

WSJ (10-29-11)

WSJ 10-22-11

Treasurys Roar Ahead – Yield on 10 – Year Note Falls Below 3%WSJ (6-2-11)

October 2011 : S&P 500 best month since 1974. The Dow best month since 1987,

and the NASDAQ strongest month in a decade.

39

OICOICBack to School for essential concepts

Dow Jones Industrial Average1960 – Present Weekly

14500

7000

11,722.90

7,528.40

6,626.94

14,093.08

$INDU (Dow Jones Industrial Average) INDX

$INDU (Weekly) 10197.47

Open 10020.62 High 10341.97 Low 10020.62 Close 10197.47 Volume 3.1B Chg +174.05 (+1.74%)

US Recession,

October 19th,

Market Down 23%

US Recession

662.17

577.60

61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

4000

2000

1000

1,766.74

2,709.50

539.19

JFK

October 1962

989.03

US Dollar and Gold “Float”

1,047.49

Recession, Interest

Rates Mid-Teens

Asian Financial

Crisis

US Recession,

9/11 Attacks

Credit Crisis

President Resigns

LTC & Russian Financial

Crisis

Historical Volatility

For any given stock:

A range of stock pricesRelative change up or down from mean (average) price

Annualized standard deviation (SD) of daily price changes

The range – a general rule of statistics

Prices within 1 SD ≈ 68% of the timePrices within 2 SDs ≈ 95% of the timePrices within 3 SDs ≈ 99% of the time

With a 25% historical volatility XYZ has beenWithin ± 1 SD of $25 from mean – 68% of the timeWithin ± 2 SDs of $50 from mean – 95% of the timeWithin ± 3 SDs of $75 from mean – 99% of the time

Historical Volatility and Standard Deviation

Not drawn to scale

$100 Mean

25 50 75 125 150 175

A little extra income…..

45

Buy-Write Strategy

The Covered Call or Buy-write strategy:

buying stock/index and simultaneously selling calls on a share-for-share basis.

Consider Selling Covered Calls

• Forecast: Neutral to moderately

Buy-Write Strategy

bullish on the stock

• Goals: Increase returns in stable markets and reduce stock price risk

Profit/Loss Diagram

Buy stock at $43.50, sell 45 Call at $2.30

5

+

Covered Call

5

40 45 50

Long stock at $43.50

0

–

Covered Call

15 Years of the Buy-Write Strategy on RUT

15 Years of the Buy-Write Strategy on RUT

$300

$350

$400

1-Month 2% OTM Buy Write Growth of $100February 1, 1996 to March 31, 2011

+263%

$100

$150

$200

$250

Fe

b-9

6

Au

g-9

6

Fe

b-9

7

Au

g-9

7

Fe

b-9

8

Au

g-9

8

Fe

b-9

9

Au

g-9

9

Fe

b-0

0

Au

g-0

0

Fe

b-0

1

Au

g-0

1

Fe

b-0

2

Au

g-0

2

Fe

b-0

3

Au

g-0

3

Fe

b-0

4

Au

g-0

4

Fe

b-0

5

Au

g-0

5

Fe

b-0

6

Au

g-0

6

Fe

b-0

7

Au

g-0

7

Fe

b-0

8

Au

g-0

8

Fe

b-0

9

Au

g-0

9

Fe

b-1

0

Au

g-1

0

Fe

b-1

1

Russell 2000 TR 2% OTM Buy Write

+227%

15 Years of the Buy-Write Strategy on RUT

1-Month Call Buy Write

Feb 1, 1996 to Mar 31, 2011

Russell

2000 TR

2% OTM

Buy

Write

ATM

Buy

Write

Annualized Return 8.11% 8.87% 7.30%

Annualized Standard Deviation 21.06% 16.57% 14.66%

Mean Monthly Return 0.84% 0.83% 0.68%Mean Monthly Return 0.84% 0.83% 0.68%

Median Monthly Return 1.68% 1.77% 1.62%

Minimum Monthly Return -20.80% -18.69% -17.84%

Maximum Monthly Return 16.51% 9.68% 10.16%

Maximum Drawdown -52.9% -42.9% -37.7%

Maximum Run Up 226.2% 264.7% 193.0%

% Down Months 38% 33% 31%

% Up Months 62% 67% 69%

Number of Months 182 182 182

15 Years of the Buy-Write Strategy on RUT

Feb 1, 1996 to Feb 28, 2003 Mar 1, 2003 to Nov 31, 2007 Nov 1, 2007 to Mar 31,2011Russell

2000 TR

2% OTM Buy

Write

ATM Buy

Write

Russell 2000

TR

2% OTM

Buy Write

ATM Buy

Write

Russell

2000 TR

2% OTM Buy

Write

ATM Buy

Write

Annualized Return 3.28% 5.49% 4.40% 20.92% 19.63% 15.79% 1.99% 2.20% 2.36%

Annualized Standard Deviation 21.83% 16.76% 15.09% 14.08% 10.52% 7.89% 26.78% 22.07% 20.02%Annualized Standard Deviation 21.83% 16.76% 15.09% 14.08% 10.52% 7.89% 26.78% 22.07% 20.02%

Correlation with RUT 1.00 0.92 0.89 1.00 0.89 0.81 1.00 0.92 0.87

Sharpe Ratio -0.06 0.05 -0.02 1.27 1.58 1.61 0.03 0.05 0.06

Mean Monthly Return 0.47% 0.57% 0.46% 1.68% 1.55% 1.25% 0.46% 0.39% 0.37%

Median Monthly Return 0.91% 1.25% 1.15% 1.70% 1.94% 1.82% 3.01% 2.21% 1.74%

Minimum Monthly Return -19.42% -18.38% -17.31% -6.84% -5.21% -4.74% -20.80% -18.69% -17.84%

Maximum Monthly Return 16.51% 8.18% 7.33% 10.73% 9.47% 7.70% 15.46% 9.68% 10.16%

Maximum Drawdown -35.1% -28.9% -26.7% -10.8% -7.5% -5.1% -52.0% -42.9% -37.7%

Maximum Run Up 93.3% 72.1% 59.7% 147.1% 130.8% 98.2% 123.0% 89.5% 75.0%

% Down Months 44% 38% 34% 30% 23% 21% 39% 37% 37%

% Up Months 56% 62% 66% 70% 77% 79% 61% 63% 63%

Number of Months 85 85 85 56 56 56 41 41 41

15 Years of the Buy-Write Strategy on RUTResults during the Financial Crisis

1-Month Call Buy Write

Nov 1, 2007 to Mar 31, 2011

Russell

2000 TR

2% OTM

Buy

Write

ATM

Buy

WriteAnnualized Return 1.99% 2.20% 2.36%

Annualized Standard Deviation 26.78% 22.07% 20.02%

Mean Monthly Return 0.46% 0.39% 0.37%Mean Monthly Return 0.46% 0.39% 0.37%

Median Monthly Return 3.01% 2.21% 1.74%

Minimum Monthly Return -20.80% -18.69% -17.84%

Maximum Monthly Return 15.46% 9.68% 10.16%

Maximum Drawdown -52.0% -42.9% -37.7%

Maximum Run Up 123.0% 89.5% 75.0%

% Down Months 39% 37% 37%

% Up Months 61% 63% 63%

Number of Months 41 41 41

From Callan Study for CBOE Oct. 2, 2006

From Callan Study for CBOE Oct. 2, 2006

Asset Allocation Analysis Zephyr AllocationADVISOR: West Chester Capital Advisors

Efficient FrontierCase: Allocation Case Return vs. Risk (Standard Deviation)

9

10

11

Large Value

Mid-Cap

Mid Growth

Mid ValueSmall Value

Emerging

Mega Cap Mega GrowthBXY

PUT

PUT/40

Courtesy of Clothier Springs Capital Management

0 10 20 303

4

5

6

7

8

Risk (Standard Deviation)

Ret

urn

Large Cap

Large Growth

Small Cap

Small Growth

US HighYld

US InvGrd

T-Bill

Mega Cap Mega Growth

Mega Value

EAFE

US Agg

US InterGov Credit

BXM

CLL

S&P 500HF-FOF Div 60/40

PUT/40

BXY/40BXM/40

And then there are the Black Swans….

57

March 11, 2011

58

If you want a little more protection….

Collar: More Downside Protection

An option hedge which is:

• Established for reduced cost/no cost • Established for reduced cost/no cost • The purchase of the put is offset by the sale of a call

Collar Profit/Loss Graph

MNO at $65.00Buy 60 Put, sell 70 Call

+

4

6

8

Maximum Gain

55

0

60 65 70 75

–

2

4

-8

-6

-4

-2

Maximum Loss

Long Stock

Collar

Gain

Collar - Summary

ADVANTAGES:• Selling calls helps to finance insurance (puts)• Limited downside risk

- Establishes minimum selling price until expiration - Establishes minimum selling price until expiration - (put strike price – net premium paid)

DISADVANTAGES:• Transaction costs• Early assignment• Can be difficult to find• UPSIDE POTENTIAL CAPPED BY THE SHORT CALL

Loosening Your Collar: Alternative Implementations of QQQ Collars

Edward Szado; Thomas Schneeweis

Active & Passive QQQ Collar study OICMarch 1999 - September 2010

Edward Szado; Thomas Schneeweis

Center for International Securities and Derivatives MarketsUniversity of Massachusetts, Amherst

Fall 2010

QQQ Collar Strategy (OptionsEducation.org/institutional) OIC

University of Massachusetts, AmherstLoosening Your Collar-11 1/2 year results (thru 9-30-2010)

+185%

+290%

-3%

+185%

University of Massachusetts, AmherstLoosening Your Collar-11 1/2 year results (thru 9-30-2010)

1/3 the risk

University of Massachusetts, AmherstLoosening Your Collar

Lower risk – Overall Period

University of Massachusetts, AmherstLoosening Your Collar – Sept. 2007 to Sept. 2010

$80.00

$100.00

$120.00

$140.00

QQQQ TR QQQQ 2% OTM PASSIVE COLLAR QQQQ Short ACTIVE COLLAR

$0.00

$20.00

$40.00

$60.00

$80.00

8/3

1/2

00

7

2/2

9/2

00

8

8/3

1/2

00

8

2/2

8/2

00

9

8/3

1/2

00

9

2/2

8/2

01

0

8/3

1/2

01

0

University of Massachusetts, AmherstLoosening Your Collar – Sept. 2007 to Sept. 2010

If you want to really protect…

70

Volatility (vol⋅a⋅tile) Origin and Definition

Origin: 1250–1300; [French, from Old French, from Latin volātilis, flying, from volātus, past participle of volāre, to fly.] 1597 "fine or light," also "evaporating rapidly" (1605). Sense of "readily changing, fickle" is first recorded 1647.

1. Evaporating rapidly ; passing off readily in the form of vapor 2. Tending or threatening to break out into open violence ; explosive 2. Tending or threatening to break out into open violence ; explosive 3. Changeable ; mercurial ; flighty

4. (of prices, values, etc.) Tending to fluctuate sharply and regularly 5. Fleeting; transient 6. Able to fly or flying

Financial Dictionary:Volatility - A statistical measure of the tendency of a market or security to rise or fall sharply within a period of time

Synonyms: eruptive, unstable, unsettled

OICOICHistorical Volatility11

A stock’s volatility in the past• can be observed and quantified• this is “historical” volatility• a statistic, or a fact, not a prediction

StockPrice

Time

Today

OICOICImplied Volatility Representsthe Future

38

Stock

Today

Implied volatility reflects current expectations aboutfuture volatility

Historical

Price

Implied

OICOICHistorical Volatility – Where to Find15

From www.optionseducation.org/quotes° then “Detailed Options Chains”

Graph from Ivolatility.com

Volatility Futures and Optionswww.cboe.com/micro/vix/introduction.aspx

V I X

--Barometer of investor sentiment & market volatility

62

volatility--implied volatility index-measures the market's expectation of 30-day S&P 500® volatility from prices of near-term S&P 500 options

--VIX standard deviation of a rate of return quoted in percentage terms.

Historic Volatilities Based on 2005 Daily Returns

www.cboe.com/micro/vix/vixoptions.aspx

63

Avg. Price Change on the 26 Days That The

S&P 500 Fell by 3% or More (1990 -2005)64

Avg. Price Change on the 33 Days when

S&P 500 Rose by 3% or More (1990 - 2005)65

10250

10750

11250

11750

12250

12750

13250

13750

14250

50.0

60.0

70.0

80.0

90.0

DJIA VS. VIXCBOE-index options new vix

DJIA

6750

7250

7750

8250

8750

9250

9750

10.0

20.0

30.0

40.0

12/1

3/02

04/0

1/03

07/1

8/03

11/0

3/03

02/2

3/04

06/0

9/04

09/2

7/04

01/1

2/05

05/0

2/05

08/1

7/05

12/0

2/05

03/2

3/06

07/1

1/06

10/2

5/06

02/1

4/07

06/0

4/07

09/1

9/07

01/0

7/08

04/2

4/08

08/1

1/08

11/2

6/08

03/1

7/09

07/0

2/09

10/1

9/09

02/0

5/10

05/2

5/10

09/1

3/10

12/2

9/10

04/1

5/11

DJIA

VIX

VIX Futures and OptionsA Case Study of Portfolio Diversification

During the 2008 Financial Crisis

OIChttp://www.cboe.com/micro/vix/VIXFuturesOptionsUMassSummary.pdf

Edward SzadoCenter for International Securities and Derivatives Markets

University of Massachusetts, Amherst

April 2009

Performance with VIX calls in late 2008(CBOE.com)

With a 3% allocation of ATM VIX calls –

-Period returns are increased from -19.7% to +20.8%,

-Period standard deviation is reduced from 25.3% to 21.1%, and

VIX Futures and Options

Portfolio Diversification During the 2008 Financial Crisis OIC

-Period standard deviation is reduced from 25.3% to 21.1%, and

-Maximum drawdown is cut in half from -32.1% to -15. 4%.

With 25% OTM VIX calls -

-Period returns increase from -19.7% to +17.7% and then to +97.2% with the addition of 1% and 3% OTM VIX calls, respectively. While,

-The period standard deviation increases from 25.3% to 28.7% and to 51.9%, and

-Maximum drawdown decreases mildly (-32.2%, -24.4% and -27.4%).