Equity Options Discussion

Transcription

1 Equity Options Discussion NOVEMBER 2013 AKIR GUTIERREZ Susquehanna Financial Group, LLLP (SFG), a member of the Susquehanna International Group of Companies (SIG), is an innovator in global finance, servicing the needs of clients worldwide in the areas of sales, fundamental research, and market intelligence. Building upon SIG s command of the options marketplace and its quantitative trading capabilities, SFG has cultivated a robust service offering that provides liquidity, industry-leading insights, and execution services. SIG employs approximately 1,500 individuals located in North America, Europe, Asia, and Australia. SFG is a member of FINRA.

2 Options Basics Call Option The right, but not the obligation to buy an asset for a specific price by a specific date. Example: Investor buys 1 IBM June 80 Call. Gives the owner the right to buy 100 shares of $80/share any time between the time of the purchase and June expiration (for American Exercise). Put Option The right, but not the obligation to sell an asset for a specific price by a specific date. Example: Investor buys 1 IBM June 80 Put. Gives the owner the right to sell 100 shares of $80/share any time between the time of the purchase and June expiration (for American Exercise). 2

3 Options Pricing Black Scholes Formula N ( ) is the cumulative distribution function of the standard normal distribution T - t is the time to maturity S is the spot price of the underlying asset K is the strike price r is the risk free rate (annual rate, expressed in terms of continuous compounding) is the volatility of returns of the underlying asset Black, Fischer; Myron Scholes (1973). "The Pricing of Options and Corporate Liabilities". 3

4 What Information Can Options Provide? Time options have an expiration date Expected price movement options have strike prices Interest rates the cost of financing a transaction Dividends the expectation for future dividend payments Expected forward price movement implied volatility of options Sentiment whether expectation are more or less positive than the past 4

5 Earnings A Known Catalyst There is a known catalysts for stocks that occurs 4 times a year where movement in the shares is likely Because it is known and it recurs, we can compare history with expectations Expectations are visible in options Example: EXPE on October 30 th But can we tell in which direction? 5

6 Earnings A Known Catalyst SKEW: In options we can also look at SKEW to give us further insight into sentiment. Skew describes how expensive the options are for a single month as you move away (equi-distant from the at the money strike). This price of the options is in implied volatility terms. The typical relation is that the downside is more expensive than the upside. The reason is that typically more events can take stocks universally lower than universally higher. So it typically costs more to purchase downside (puts) than upside (calls). Sym Close PC YTD(%) IV RV Sprd IV Rnk 2 Yr Skew(%) Avg. Skew(%) Skew Rnk 2 Yr 1wk Skew 1M Skew Volume Sector EXPE $ ,790 Consumer Discretionary 6

7 Earnings A Known Catalyst The options implied move is +/- 14%. This is ~4% greater than the average of the last 4 quarters. EXPE skew (see below) is near its lows with a 2 year 15.31%-ile rank. This is typically indicative of positive sentiment into the earnings report. If EXPE reports in line with their guidance and does not surprise on the outlook: Expect a +14% type move If EXPE surprises to the upside: Expect a slightly larger than +14% type move (though significantly more upside will likely be gated by the already positive skew) If EXPE misses and or guidance is viewed negatively look for a gap down well beyond -14% as the market would be caught by surprise EXPE reports earnings that are positively received: Shares +18% 7

8 Earnings A Known Catalyst 8

9 What else can the options market tell us? Informational Advantages may be obtained through estimates of: Implied Earnings Moves Implied Dividends Implied Probability Term Structure - When in time catalysts are being expected 9

10 What Can An Options Transaction Tell You? ACN: In Accenture, an opening investor sold ~20k Dec 77.5 (.25d) calls for $0.80, net selling 500k deltas vs. ~130k on tape at the time (with 60-day IV trading in the 54th percentile with IV vs. RV spread rank in 70th percentile). Earnings are expected 12/19. ACN ~$73. This is interesting for a few reasons: An opening investor sold ~20k Dec 77.5 (.25d) calls for $0.80. This means that this investor has sold these calls into the market, and it was not an existing position. This is typically done by a holder of shares overwriting their holding with the intent of taking in the proceeds from the sale as income. As a reminder 20K contracts is the nominal equivalent of 2 million shares. So it is likely that the investor has overwritten 2 million share holding. So what assumptions does the investor reveal? 1) That they have a price target of $77.50 on the shares otherwise it would be irrational to sell those calls as you would cap your upside as an ACN holder. By overwriting they are signaling a comfort with exiting their position at that level. 2) They think that ACN will achieve that target by December expiration, which also captures the next know catalyst for the shares: earnings. 10

11 Appendix: implied earnings moves how is it calculated? (Part 1) OPTIONS DISCUSSION Assumptions: Of the 29 days within August expiration, 28 are non-event days, with the same volatility, leaving 1 earnings vol day with its own volatility If we can make an assumption for the 28 non-event volatility days, we can reconcile with August implied volatility to back out that 1-day volatility. We will assume that aside from earnings, there are no other catalysts within either August or September expiration So, we can use September implied volatility to figure out our proxy for nonevent volatility. Because September options also contain earnings in August, though, we have to figure out the forward volatility between August and September expiration (i.e. September options are composed of the time period between now and August expiration, and the time period between August expiration and September expiration this is the forward volatility we need to isolate). Volatilities are not additive, but variances are (volatility is the square root of variance). September implied volatility is a weighted average of August variance and August-September forward variance. 29/57(.65^2) + 28/57(x^2) = 57/57(.56^2) In aggregate, the 57 days of September options are trading at 56% vol, this is comprised of 29 days at 65% (august volatility) and 27 days at the forward volatility we are solving for (x). Solving that equation, we get x=.45, or 45% SKX Spot $35 Earnings Date August Implied Volatility 65% September Implied Volatility 56% August Options (Time to Expiry) September Options (Time to Expiry) 29d 57d 11

12 Appendix: implied earnings moves how is it calculated? (Part 2) OPTIONS DISCUSSION So, we are really saying that September volatility of 56% is composed of 29 days of August vol at 65% and 27 days at the forward volatility between August expiration and September expiration at 45%, this forward volatility will be our estimate for non-event volatility. Now that we have an estimate for non-event volatility, we can plug that into the same equation for the composition of August volatility. 28/29(.45^2) + 1/29 (y^2) = 29/29(.65^2) In aggregate, the 29 days of August options are trading at 65% vol, this is comprised of 29 days at 45% volatility, or non-event volatility, and one day of earnings volatility which we are solving for (y). Solving that equation, we get y = 2.57, or 257% So, we have solved for an earnings volatility standard deviation of 257%. However, this is an annualized number, so to put it in one-day terms, we have to multiply it by the square root of time (1/252 trading days). 257% * (square root (1/252)) = 16.2% (since the square root of 252 is 15.87, we typically take the annualized standard deviation and simply divide it by 16) We can estimate that the options market is pricing in a +/- 16% move on earnings. Caveats/Where we can be wrong: Assumption that there are no other catalysts. Assumption that all days other than earnings are the same. Not accounting for weekends, holidays, etc. We are assuming a flat volatility term structure between front two months. 12

13 Risks 13 Buying Call: If at expiration the stock finishes below the strike price, the risk to the investor is losing the entire premium paid. The call is profitable if at expiration the stock finishes above the strike price plus the premium paid for the call. Buying Call Spread: Buying a call spread is buying a call and selling a call with a higher strike that has the same underlying and expiration. If at expiration the stock finishes below the lower strike price, the risk to the investor is losing the entire premium paid for the spread. The call spread is profitable if at expiration the stock finishes above the lower strike price plus the premium paid for the call spread. The call spread s maximum payout occurs when the stock finishes at the higher struck call at expiration. Buying Put: If at expiration the stock finishes above the strike price, the risk to the investor is losing the entire premium paid. The put is profitable if at expiration the stock finishes below the strike price minus the premium paid for the put. Buying Put Spread: Buying a put spread is buying a put and selling a put with a lower strike that has the same underlying and expiration. If at expiration the stock finishes above the higher strike priced put, the risk to the investor is losing the entire premium paid for the spread. The put spread is profitable if at expiration the stock finishes below the higher strike price minus the premium paid for the put spread. The put spread s maximum payout occurs when the stock finishes at the lower struck put at expiration. Buying Straddle: Buying a straddle is buying a call and buying a put with the same underlying, strike and expiration. If at expiration the stock finishes at the strike price, the maximum loss occurs of the total premium paid. The straddle is profitable if at expiration the stock finishes above the strike plus the total premium paid or below the strike price minus the total premium paid. Selling Call: (Naked no underlying stock position) If at expiration the stock finishes above the strike price, the risk to the investor is unlimited. The short call is profitable if at expiration the stock finishes below the strike price plus the premium collected for the call. (Covered versus an underlying stock position) If at expiration the stock finishes above the strike price, the risk to the investor is limiting their upside profit on long stock to strike price plus premium collected for the call. If at expiration the stock finishes below the strike price, the investor profits on the premium collected from the call sale which may help enhance stock returns or offset stock loses. Selling Call Spread: Selling a call spread is selling a call and buying a call with a higher strike that has the same underlying and expiration. If at expiration the stock finishes above the lower strike price, the risk to the investor is losing the entire premium collected for the sale, with a maximum loss of the difference between the strikes minus the premium collected. The call spread is profitable if at expiration the stock finishes below the lower strike price plus the premium collected for the call spread. The call spread sale s maximum payout occurs when the stock finishes at the lower struck call at expiration. Selling Put: One risk to selling a put is that if assigned on the short put, investors will be forced to buy shares at the strike price, minus any premium collected for the sale. If at expiration the stock finishes below the strike price, the maximum risk to the investor is the strike price minus the premium collected. The put is profitable if at expiration the stock finishes above the strike price and the investor collects the premium for the put sale. Selling Put Spread: Selling a put spread is selling a put and buying a put with a lower strike that has the same underlying and expiration. If at expiration the stock finishes below the higher strike priced put, the risk to the investor is losing the entire premium collected for the sale of the spread, with a maximum loss of the difference between the strikes minus the premium collected. The put spread is profitable if at expiration the stock finishes above the higher strike price minus the premium collected for the put spread. The put spread s maximum payout occurs when the stock finishes at the higher struck put at expiration. Selling Straddle: Selling a straddle is selling a call and selling a put with the same underlying, strike and expiration. If at expiration the stock finishes above the strike price plus the total premium collected or below the strike price minus the total premium collected, the maximum loss is unlimited. The straddle is most profitable if at expiration the stock finishes at the strike price and the investor collects the premium.

14 Regulatory Disclosures This material has been prepared by the Market Intelligence Team of SFG for informational purposes only and is not meant to be viewed as a complete analysis of any security. Options trading involves a high degree of risk and is not suitable for every investor. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (ODD). Copies of the ODD and OCC Prospectus are available by calling OPTIONS, or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois The risks and potential profit and loss vary with the option strategy employed, while certain strategies may mitigate risk, others, such as uncovered call options, may result in unlimited losses. All calculations assume the positions are maintained until the expiration date of the particular option illustrated unless otherwise stated. Note that short options may be assigned prior to expiration and result in returns higher or lower than those illustrated. Past performance should not be taken as an indication or guarantee of future results. Prices are subject to market fluctuations and to availability. As with all option strategies, deviations from the reference prices due to market price fluctuations may affect the ability to execute at stated prices and could cause returns to be different from those illustrated. Supporting documentation for any claims (including any claims made on behalf of options programs or the options expertise of sales persons), comparisons, recommendations, statistics or other technical data, will be supplied upon request. SIG, its affiliates and/or its principals may have long or short positions in securities or related issues mentioned here. SIG, in its capacity as specialist and/or market maker, may execute orders on a principal basis in the subject securities. Information presented is from sources believed to be reliable, but is not guaranteed to be accurate or complete. The analyst primarily responsible for this report attests that the views expressed accurately reflect his or her personal views and that no part of his or her compensation was, is, or will be related to any specific views in any report. SFG does and seeks to do non-investment banking business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. SFG intends to represent issuers, including one or more of the subject companies, as a broker in connection with corporate repurchase plans. Research analysts may receive compensation for their efforts involving corporate repurchases. This is a proprietary SFG product prepared, and intended, solely for the use of sophisticated and professional institutional traders and managers and not for the general investing public. Unauthorized redistribution of this report, by any means, represents a violation of US copyright laws and could result in legal action and the suspension of the intended recipient s privileges. If you have any questions regarding this transmission please contact ResearchDistribution@sig.com. Copyright 2012 Susquehanna Financial Group, LLLP. All rights reserved. 14