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For Newbie Option Traders, Grasping Volatility Is A Must

As an options trader, implied volatility and time decay are two critical components to keep an eye on. This article will focus on volatility for those just beginning to dabble in options. At the end of the article a short explanation of time decay is included.

Markets determine option buy points by using forward-looking pricing models. A number of financial pricing models exist. Two of the most popular models include binomial option pricing and Black-Scholes option pricing, as explained by Penn’s Wharton School of Business in the above link.

Implied volatility is an estimate of an option’s future volatility and is determined (or implied) by live market prices. Because implied volatility can only be estimated it is important to understand the distinction between implied volatility and volatility:

Implied volatility: forward-looking volatility estimates linked to current price.

Volatility: observable historical figures that put implied volatility in perspective. This comparison helps a trader determine if an option is under or over-valued.

Volatility measures an investor’s risk. A financial instrument’s value changes over a specific time horizon. Collectively these values form a population. Volatility equals the positive square root of the population’s variance (or standard deviation for you statistics fans out there). The “time horizon” is typically a year and the “population” is the collection of daily price changes of the financial instrument. So we say that volatility is the “annualized standard deviation of a stock’s daily price changes.”

A fascinating side note about option valuation: did you know that beliefs regarding the movement of an underlying asset’s future value do not factor into an option’s valuation?! Clashing expectations about an asset’s expected growth and returns will not stop two people from entering into an option contract. Only agreement regarding volatility and the risk-free rate of return are necessary. The costs of hedging after writing an option always remain the same regardless of an asset’s price going up or down.

Time decay of an option is the idea that options carry expiration dates. An option is a contract that gives an investor the right to buy or sell a specific quantity of a financial security. They may buy or sell at a predetermined price until the date of expiration. Once the contract expires, it is valueless. Time decay refers to the notion that an option’s value erodes the closer it gets to it’s expiration day. Time decay is accounted for by The Greeks, statistical values that option traders use. Namely, theta represents the absolute value erosion for “one period” of time. For example, if the strike price of an option was $500 and theta was equal to $50, theoretically the option would lose $50 of value each day.

The first step for a newbie option trader is to get comfortable with using statistical values. Using the likes of implied volatility and volatility will help determine if an option is under or over-valued. The next step is developing trading strategies to effectively use those valuations.

Published in Main by Ernest Simmons.

Absolute Returns for Individual Investors: Volatility, Part I

In late 2007, Goldman Sachs released a research note entitled “Volatility as an Asset Class,” where they argued that the diversified returns from strategies involving equity index volatility made it worthy of an allocation from investors. While I disagreed with their particular approach because of risk management concerns, the underlying point – that strategies involving volatility can generate returns independent of favorable equity markets – is well-presented and should be considered.

What is Volatility?

Because all the inputs into options pricing formulas are observable (e.g. strike price, current price, time to expiration, interest rates) except for volatility, it is essentially the “plug” in the formula that brings the option’s market price in line with its theoretical price. The exact definition of volatility is up to debate – some people believe it is expected standard deviation, others believe it is a fictional number showing how expensive or cheap an option is. For argument’s sake, let’s assume that volatility is simply related to demand for options on an index like the S&P 500. Options are most valuable when prices are expected to diverge widely, which is why higher variability of stock market returns coincides with more expensive options (for more, see “Why Options are More Valuable Now Than Ever Before”)

However you define volatility, you will keep coming back to the relationship between higher volatility, larger expected stock market moves, and higher options prices. What’s important is that trading volatility lets one bet on options prices without having the same “delta risk” of a regular put or call option on a stock or index. For a typical at-the-money option, delta – the change in an option’s price compared to a change in the stock or index – will represent the majority of the option’s change in price. But dealing directly with volatility (like the VIX) changes things.

Trading Volatility

Currently, a volatility index such as the VIX cannot be purchased directly in the same way a stock can. Instead, there are options on the VIX which individual investors can use to get exposure to volatility. Any number of options strategies can be replicated using volatility, including a synthetic long position by being long a call and short a put (or a synthetic short by being short a call and long a put).

As eluded to in the discussion of delta above, volatility options require a slightly different framework. The underlying reference is volatility itself – so the delta of a volatility option position equates to changes in volatility. The “volatility” for VIX options is now the volatility of… volatility. It might seem complicated, but is actually more common sense than it might come across.

Asset Class Upside

If you believe the Goldman argument that volatility is its own asset class – and I do, given the number and type of products linked to it – the logical follow-up is to see what value that asset class can offer.

The long-dated chart below shows the relationship between the S&P 500 and the VIX volatility index. Although not perfect, there is an inverse relationship that could make volatility useful as a portfolio hedge or for speculation. Examples of each will be explored more fully in the next part of this series.

Published in Main by Ernest Simmons.

Understanding Binary Options

Binary options are good for beginners that want to get their feet wet, without worrying too much about all the jargon used in trading stocks. With binary options you either win or lose – there is no in between. The basic concept is that you buy a contract, either in the buy or sell mode and if the stock does as you predict you will receive money and if you were wrong, you lose it all.

Of course, this can still be quite confusing. Binary options are not available with each and every stock out there. A matter of fact, it can be hard to find the ones that offer this option.

The CBOE lists two stocks with binary options – VIX and SPX. The American Stock Exchange lists stocks with binary option as FRO and include Apple, Inc (AAPL), Cisco Systems, Inc (CSCO), Citigroup Inc (C), DIAMONDS (DIA), General Electric (GE), Goldman Sachs (GS), Google Inc CL.A (GOOG), Home Depot (HD), IBM (IBM), Intel (INTC), iShares MSCI Emerging Markets (EEM), iShares Russell 2000 Index Fund (IWM), JP Morgan Chase (JPM), Microsoft CORP (MSFT), Oil Service HOLDRS (OIH), PowerShares QQQ (QQQQ), SPDR S&P 500 (SPY), Select Sector SPDR-Energy (XLE), Select Sector SPDR-Financial (XLF) and Wachovia Corp (WB). Every stock exchange has their own binary options, so you will have to learn which ones are available with this type of option or listed as FRO’s.

Now, to explain the concept. Binary options give investors a wide variety of trading options in that some are short-term trades while others may be quarterly since they are based on the date of expiration. You as a binary option trader will choose the stock that you wish to buy or sell by if you believe the price will go up or down on the date of expiration. If you think the market price is going to be higher then you buy. If you believe the market price will go down then you sell. If you choose correctly, then you receive payoff on each contract you had on that stock.

Normally, the price you will receive is a fixed amount, such as $100. This means you will receive $100 for each correct contract. If you buy and spend $25 and the stock rises or are equal to the strike price on expiration, you will receive $100 for each contract. However, if you are not correct you will lose your investment all together.

Metals and energy can also be bought and sold with binary options and be watched through the New York Mercantile Exchange. With the economy the way it has been heading, many investors are buying and selling foreign currency with the hopes of making a quick buck while others are looking to natural gas or crude oil.

Example of buying a stock with binary options

  • MAM Forex
  • The strike price for buying (calls) is at 20000
  • The strike price for selling (puts) is at 8000

Looking at the market and the strike prices you can make an educated decision in which way you believe the stock will go. Let’s say you buy. The last strike price for calls was at 15000 and now it is at 20000. When you buy in you are saying the price of light sweet crude oil will be at 2000 or more on the date of expiration. If you are correct, you will then receive the set amount of money, usually $100, per contract.

Example of selling a stock with binary options

If you put on light sweet crude oil, believing the strike price of 8000 will be that or less then you will receive $100 per contract if the set amount is such.

However, in both scenarios if you are incorrect and the strike price goes down with a call or up with a put then you will lose all money invested.

Example of buying or selling a stock with binary options long term

You can also call and put with stocks that do not have an expiration, except quarterly. This allows you a few more options. You can always change your mind, however, you will only receive the money you put into the stock.

If you have a contract for Gold in the amount of $80 but now you do not believe the price will be the same or more, you have the option of selling. Of course, you will sell at a loss, but you will not lose your entire $80.

However, if you leave it the same and you were correct in your speculation, you will receive the set amount of money per contract.

You need to watch the binary option price the stock is selling at. This can be a great way to make an educated decision if the stock with rise or plummet on the expiration dates.

Published in Main by Ernest Simmons.

Notes on the Interesting Times in the Options Markets

Stress in the financial markets has been spilling over into other areas, affecting equities, derivatives, and a wide array fixed income products. Because of their multiple uses and leveraged nature, the equity derivatives market is an especially interesting point of study, because the behavior of numerous speculators and hedgers is colliding in an increasingly uncertain world. There are a number of unusual developments all options traders need to keep in mind, and I was lucky enough to speak with a contact who works the equity derivatives trading desk at a major investment bank many would call the best on Wall Street. Naturally, most of these also have applications to the regular equity markets as well. A few notes, interspersed with my comments…

One puzzle of the options market lately has been the lack of the VIX making new highs as the broader market makes new lows; typically, the VIX moves inversely to the S&P 500. Perhaps more importantly, the VIX is still relatively low even as broader market volatility seems very high; 2%+ moves have become a frequent occurrence. Why, then, is the VIX 30% off its 52-week high when the S&P 500 is setting new lows, and is 21% below its 52-week high? This has to do with many funds becoming net short the market, and thus not seeking protection via purchasing puts. Instead, they are selling stock – which drives the market lower, but doesn’t send the VIX higher. If you think of the asymmetry presented by institutions being net short, it seems the VIX will move lower more easily than it moves higher, because the likely course of action would be to buy calls to quickly offset short positions.
Taking this a step further, I’ve chronicled a number of indicators of market internals and how far into the oversold area they are getting. The noteable exception was the lack of a blowout in the put/call ratios – but this pretty much explains that. If you’re willing to place a contrarian bet, the oversold levels we’re reaching combined with the big money already being net short may lead to a snapback rally in the equity markets on any positive news.

Earlier options articles on this site note that volatility is a component of an option’s price; by being long a call, for example, one is inherently long volatility. While volatility isn’t at an extreme, it’s noteworthy to point out that speculating on a breakout rally with calls has an added risk – being directionally correct and seeing the markets go up, but having those gains mitigated as volatility falls. Better, perhaps, to use a spread strategy – i.e. bull call – to reduce the net long vega. Also, don’t be afraid to step back from the at-the-money options positions into far-into or far-out-of the-money situations; according to this trader, many professional volatility traders have done so because the huge intraday market swings make it difficult to exercise proper risk management.
Everybody wants to think about making money, but it often pays more to think about how not to lose it.

Published in Main by Ernest Simmons.

Understanding The Greeks

Volatility

Volatility can be a very important factor in deciding what kind of options to buy or sell. Volatility shows the investor the range that a stocks price has fluctuated in a certain period. The official mathematical value of volatility is denoted as “the annualized standard deviation of a stocks daily price changes.”
There are two types of Volatility: Statistical Volatility and Implied Volatility.
Statistical Volatility – a measure of actual asset price changes over a specific period of time.
Implied Volatility – a measure of how much the “market place” expects asset price to move, for an option price. That is, the volatility that the market itself is implying.
The computation of volatility is a difficult problem for mathematical application.
In the Black-Scholes model, volatility is defined as the annual standard deviation of the stock price. There is a way in which the strategist can let the market compute the volatility for him. This is called using the implied volatility – that is, the volatility that the market itself is implying. This is similar to an efficient market hypothesis. If there is enough trading interest in an option that is close to the money, that option will generally be fairly priced.

The Black-Scholes Formula

The Black-Scholes formula was the first widely-used model for option pricing. This formula can be used to calculate a theoretical value for an option using current stock prices, expected dividends, the option’s strike price, expected interest rates, time to expiration and expected stock volatility. While the Black-Scholes model does not perfectly describe real-world options markets, it is still often used in the valuation and trading of options.

The variables of the Black Scholes formula are:

  • Stock Price
  • Strike Price
  • Time remaining until expiration expressed as a percent of a year
  • Current risk-free interest rate
  • Volatility measured by annual standard deviation.

The Greeks

The Greeks are a collection of statistical values (expressed as percentages) that give the investor a better overall view of how a stock has been performing. These statistical values can be helpful in deciding what options strategies are best to use. The investor should remember that statistics show trends based on past performance. It is not guaranteed that the future performance of the stock will behave according to the historical numbers. These trends can change drastically based on new stock performance.

Delta: The Delta is a measure of the relationship between an option price and the underlying stock price. For a call option, a Delta of .50 means a half-point rise in premium for every dollar that the stock goes up. For a put option contract, the premium rises as stock prices fall. As options near expiration, in the money contracts approach a Delta of 1.
In this example the delta for stock XYZ is 0.50. As the price of the stock changes by $2.00 the price of the options will change by 50 cents for every dollar. Therefore the price of the options will change by (.50 x 2) = 1.00. The call options will have their price increased by $1.00 and the put options will have their price decreased by $1.00. The Delta is not a fixed percentage. Changes in price of stock and time to expiration will have an effect on the delta value.

Gamma: Sensitivity of Delta to unit change in the underlying. Gamma indicates an absolute change in delta. For example, a Gamma change of 0.150 indicates the delta will increase by 0.150 if the underlying price increases or decreases by 1.0. Results may not be exact due to rounding.

Theta: Sensitivity of option value to change in time. Theta indicates an absolute change in the option value for a ‘one unit’ reduction in time to expiration.

Vega (kappa, omega, tau): Sensitivity of option value to change in volatility. Vega indicates an absolute change in option value for a one percent change in volatility. For example, a Vega of .090 indicates an absolute change in the option’s theoretical value will increase by .090 if the volatility percentage is increased by 1.0 or decreased by .090 if the volatility percentage is decreased by 1.0. Results may not be exact due to rounding.

Rho: Sensitivity of option value to change in interest rate. Rho indicates the absolute change in option value for a one percent change in the interest rate. For example, a Rho of .060 indicates the option’s theoretical value will increase by .060 if the interest rate is decreased by 1.0. Results may not be exact due to rounding.

Published in Main by Ernest Simmons.

FRO Market Clarifies Bets on Goldman Sachs (GS)

An extremely helpful side effect of the pricing and payoff structure of a binary option (such as a Fixed Return Option, or FRO) is that the bid and ask both represent the probabilities the buyer and

seller assign to an event happening. Binary options paying $100 or $0 depending on whether or not the government will pass a “bailout bill” for the financial system before the end of September, for example, last traded at $65 – meaning that

this market is assigning about a two-thirds chance such legislation will be passed. The market pricing of these useful instruments, then, allows everyone to see the odds people with conviction enough to bet real money – not just TV pundits – have an event will occur.

In the financial space, the FRO market on individual stocks allows us a glimpse into what price traders believe the referenced security will be at on a certain date. One of the most watched stocks of late is investment bank-turned-regulated bank Goldman Sachs (ticker: GS), which has stood strong even as rival firms have collapsed. The crisis of confidence gripping the financial system, however, threatens even the best of firms with liquidity shortages – one reason Goldman Sachs recently recapitalized to the tune of nearly $10 billion in new equity. With this new liquidity and a wide-open competitive landscape, is Goldman poised to emerge on the other side of the credit mess with tremendous earnings potential, or is it destined to be brought down as well?

The following two charts were constructed from the bids on a range of front-month (October) FROs on Goldman Sachs. This diagram from the long perspective (betting whether Goldman will finish at or above the specified strike price) using the Finish High FROs says that traders believe the current $133 price is essentially a coin flip.

But the following chart from the bearish perspective made using Finish Low FROs suggests that the pessimism about downside risk does not match with the indecisiveness bullishness. Traders are saying that the “50%” price is $145 – meaning they believe there is a 50% chance Goldman Sachs finishes under $145 at contract expiry – or almost 9% higher than Goldman’s current stock price. In fact, the odds say there is less than a one-in-three chance Goldman’s stock doesn’t increase between now and expiration, and the odds of a large decline show a marked drop-off.

Published in Main by Ernest Simmons.

Fixed Return Options (FROs) Offer Overlooked Shorting Opportunity

The dramatic series of policy decisions affecting our capital markets in the last week generally requires extremely nuanced discussion of the pros and cons, with one exception – the ban on shorting financial stocks. This is a complete perversion of free market principles and will do more to add to market inefficiency than anything else. Shorting is natural and helps the markets function by allowing people to take the other side of a trade, but the practice has unfortunately caught the populist wrath because it allows some to profit off the misfortune of others.

Regardless of one’s views of the new policy, it’s going to be a game changer for the markets, and smart traders need to trade the environment they’re in, rather than trade the environment they wished for. This ban on short selling select financials is going to cause the market to function in ways it hasn’t before, namely that the use of a “synthetic short” will cause traditional options to get much more expensive. A synthetic short is a combination of a long put and a short call, and offers the same payout structure as a traditional short stock position. Because this is going to become the main avenue to bet on a stock’s decline, the increase in demand will drive up the implied volatility cost.

The net result is that a regular options bet on a company might not be the most economical way to trade – savvy options traders know much more is built into a regular option price than just delta, or the directional component. And with artificially high implied volatility on regular options, a Fixed Return Option (abbreviated as “FRO”) might become the better choice for options traders in stocks like Citigroup (ticker: C), Goldman Sachs (GS), JPMorgan (JPM), and Wachovia (WB) – all stocks subject to the short-selling ban which have exchange-listed FRO markets.

Just because the government has stepped in to backstop the financial markets doesn’t mean to ignore the Finish Low FRO, either – in fact, it probably means you should zero in on potential opportunities there. On a weekly basis, the S&P was essentially flat. Does that make sense given the huge number of fundamental problems that have surfaced, and the time that will be required to resolve them? I’ve been skeptical of rallies in the financials, so this monumental effort to support them gives me pause, but I’m not about to go buy a basket of bank stocks. Too few institutions have deleveraged, or failed trying and either gone under or been consolidated out of existence, to make me think a bottom is in on the equity side.

In the meanwhile, keep in mind that implied volatility on options contracts is extremely high – and trading traditional options could be set to get pricier as short hedge funds and the like flock to the options pits to replicate bets against financial companies. Finish Low FROs are an underutilized tool that can provide a payoff similar to shorting, and could prove an invaluable addition to the trader’s toolbox in the coming months.

Published in Main by Ernest Simmons.