OPTIONS TRADING AND VOLATILITY. Presented by Jason Ayres DMS Montréal Exchange Instructor In partnership with BMO InvestorLine
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1 OPTIONS TRADING AND VOLATILITY Presented by Jason Ayres DMS Montréal Exchange Instructor In partnership with BMO InvestorLine 1
2 Disclaimer Montréal Exchange The views and opinions expressed in this presentation reflect those of the individual authors/presenters only and do not represent in any way Bourse de Montréal Inc. s (the Bourse ) opinion or any of its affiliates. The presentation is not endorsed by the Bourse or its affiliates. The information provided in this presentation, including financial and economic data, quotes and any analysis or interpretation thereof, is provided solely on an information basis and shall not be interpreted in any jurisdiction as an advice or a recommendation with respect to the purchase or sale of any derivative instrument, underlying security or any other financial instrument or as a legal, accounting, tax, financial or investment advice. The Bourse and its affiliates do not endorse or recommend any securities referenced in this presentation. The Bourse recommends that you consult your own advisors in accordance with your needs. Although care has been taken in the preparation of these articles, the Bourse and/or its affiliates do not guarantee the completeness of the information contained in this presentation, and are not responsible for any errors or omissions in or your use of, or reliance on, the information. The Bourse reserves the right to amend, review or delete, at any time and without prior notice, the content of this presentation. The Bourse, its affiliates, directors, officers, employees and agents will not be liable for damages, losses or costs incurred as a result of the use of any information appearing in this presentation. BMO InvestorLine 2 BMO InvestorLine Inc. is a member of BMO Financial Group. Registered trade-mark of Bank of Montreal, used under license. BMO InvestorLine Inc. is a wholly owned subsidiary of Bank of Montreal Holdings Inc. Member Canadian Investor Protection Fund and IIROC. All market data illustrated in this presentation is provided by a third party vendor. The opinions and views expressed in the following presentation are that of the speaker and not necessarily BMO InvestorLine Inc. This presentation is prepared as a general source of information and is not intended to provide legal, investment, accounting or tax advice, and should not be relied upon in that regard. If legal or investment advice or other professional assistance is needed, the services of a competent professional should be obtained. Information contained in this presentation does not constitute and shall not be deemed to constitute advice, an offer to sell/ purchase or as an invitation or solicitation to do so for any entity. The content of this presentation is based on sources believed to be reliable, but its accuracy cannot be guaranteed. BMO InvestorLine Inc. and its affiliates, sponsors and employees do not accept responsibility for the content and makes no representation as to the accuracy, completeness or reliability of the content and hereby disclaims any liability with regards to the same. Options are not suitable for all investors. Investing in options carries substantial risk and tax consequences. Investors may realize losses on any investments made utilizing leverage. Future returns are not guaranteed, and use of leverage may magnify trading losses.
3 Agenda Complexities of options pricing Why volatility is important Offsetting volatility with debit spreads Selling volatility 3
4 The Complexities of Option Prices Stock price Strike price Time Interest rates Dividends Volatility Adjustment for risk 4
5 Why is Volatility Important? Adjustment for risk Implied volatility will be impacted by Company earnings Pending announcements or mergers Economic or market environment 5
6 Implied vs. Historical Volatility Historical volatility Past realized volatility Measured by the average deviation of the share price from its average price Implied volatility Markets expectation of future volatility Is the probabilities adjustment for the option price Creates a probabilities distribution curve 6
7 Normal Distribution Bell Curve $ % $55 $30 $35 $40 $45 $50 $55 $60 $65 $70 7
8 Expanding Implied Volatility The environment changes creating a period of anticipated high volatility Volatility will expand adjusting the price of options Rate of change measure called the Vega 8
9 Expanding Implied Volatility $ % $58 $30 $35 $40 $45 $50 $55 $60 $65 $70 9
10 Contracting Implied Volatility The environment changes creating a period of less volatility Volatility will contract adjusting the price of options 10
11 Contracting Implied Volatility $ % $53 $30 $35 $40 $45 $50 $55 $60 $65 $70 11
12 Periods of Low Implied Volatility Call and put options are cheap from a historical perspective For the option buyer, this is an opportunity to buy longer term options at a reduced cost For the option writer, this is a period of less premium leading to more at-the-money writing 12
13 Periods of High Implied Volatility Call and put options are expensive from a historical perspective For the option buyer, option premiums are higher and there is the risk of loss from a volatility crash For the option writer, this is a period of healthy premiums for at-the-money or out-of-the-money 13
14 Periods of High Implied Volatility Option buyers often seek to offset the cost of the more expensive options Ideal time to consider debit spreads 14
15 Offsetting Volatility Debit Spreads 15
16 Debit Spreads Offset the cost of expensive options Reduce the break even point of the trade Reduce the potential loss if the underlying moves adversely Lose upside profit beyond sold strike 16
17 Bull Call Spreads Bullish outlook Buy 1 call option Sell 1 call option with a higher strike Same stock or ETF Same expiration 17
18 Example Barrick Gold (ABX) ABX is at $19.00 on October 18 th, 2013 Buy 1 December $19.00 call for $1.35 (debit) Sell 1 December $22.00 call for $0.40 (credit) Net cost is $
19 Bull Call Spread Option Selection BUY SELL 19
20 Bull Call Spread Risk Graph ABX Break Even = $ $0.95 = $19.95 $ $0.00 $17.00 $18.00 $19.00 $20.00 $21.00 $ $
21 Bull Call Spread on ABX Maximum profit = spread - debit $3.00 $0.95 = $2.05 Break even = purchased strike + debit $ $0.95 = $19.95 Maximum loss = net debit $
22 Bear Put Spreads Bearish outlook Buy 1 put option Sell 1 put option with a lower strike Same stock or ETF Same expiration 22
23 Selling Volatility Selling Covered Calls and Puts 23
24 Periods of High Implied Volatility Call and put options are expensive from a historical perspective For option writers, this a period of healthy premiums at or out-of-the-money 24
25 Covered Call Writing You buy or own a stock Sell 1 call option for every 100 shares You get paid to take on the obligation to deliver the stock to the option buyer at a specific price over a specific period of time 25
26 Low Volatility Example Buy 1,000 shares of EnCana (ECA) 1,000 x $18.00 per share = $18, month $19.00 call trading at $0.30 Implied Volatility is 33% Sell 10 calls (covered) You collect $ (1.6%) for the obligation to sell the 1,000 shares of ECA over the next 1 month at $
27 Higher Volatility Example Buy 1,000 shares of EnCana (ECA) 1,000 x $18.00 per share = $18, month $19.00 call trading at $0.95 Implied volatility increases to 70% Sell 10 calls (covered) You collect $ (5%) for the obligation to sell the 1,000 shares of ECA over the next 1 month at $
28 Selling Put Options You do not own any stock yet, but may be obligated to own it in the future You get paid to assume the obligation to buy 100 shares for each put sold at a specific price over a specific period of time 28
29 Low Volatility Example Barrick Gold Corp (ABX) is trading at $ month $18.00 put is trading at $0.50 Implied volatility is 40% Sell 10 puts (uncovered) You collect $ for the obligation to buy 1,000 of ABX over the next 1 month at $ % in 1 month 29
30 Higher Volatility Example Barrick Gold Corp. (ABX) is trading at $ month $18.00 put is trading at $0.80 Implied volatility increases to 62% Sell 10 puts (uncovered) You collect $ for the obligation to buy 1,000 shares of ABX over the next 1 month at $ % in 1 month 30
31 Conclusions Implied volatility has a significant impact on option pricing Investors can identify changes in the implied volatility variable to Help with strategy selection Manage expectations for performance and returns 31
32 To Learn More... The Montréal Exchange provides e-learning tools: Blog (optionmatters.ca) Videos and webinars Trading guides Covered call calculator Options calculator Options simulator For more information, visit and 32
33 Questions? 33
34 Thank you! 34
35 35
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