Implied Volatility and Profit vs. Loss. Presented by The Options Industry Council

Implied Volatility and Profit vs. Loss Presented by The Options Industry Council

Implied Volatility and Profit vs. Loss Options involve risks and are not suitable for everyone. 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 or The Options Industry Council at One North Wacker Drive, Chicago, IL 60606. In order to simplify the computations, commissions, fees, margin interest and taxes have not been included in the examples used in these materials. These costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax advisor about any potential tax consequences. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Past performance is not a guarantee of future results.

Presentation Outline Volatility review - what is volatility? - kinds of volatility - effects of changing implied volatility on calls and puts - implied volatility and stock price variance Measuring changes in implied volatility - Vega Implied volatility in the marketplace - implied volatility behavior - Implied volatility and your positions Examples

Volatility Review Volatility represents price fluctuation - of underlying stock over time - no bias for up or down move - quantified as one standard deviation price change (in %) 2 Stocks over time begin and end at same price More volatile = Less volatile =

Volatility Review Key factor of pricing model and theoretical values - input for model is an assumption - shorter-term options - key unknown - longer-term options - key unknown (+ interest risk) Increasing volatility - option buyers pay more for more stock fluctuation - option sellers want more for increased risk Decreasing volatility - buyers pay less for smaller fluctuation - sellers take less for decreased risk

Historical and Expected Volatility Historical volatility - observed and measured underlying stock fluctuation - over time usually 1 year - can be recalculated daily will change - a fact, not a prediction Expected volatility - prediction of future stock price fluctuation - totally subjective your call ultimately History may or may not repeat itself!

Implied Volatility Applies to options - volatility assumption at which option is currently priced - obtained via option pricing model - consensus of marketplace - not necessarily right or wrong Can be at great variance with historical volatility - can be highly dynamic - may change intra-day sometimes significantly - may or may not come in line with historical - may apply to single option series or class of options

Effects of Changing Volatility Change in Volatility (Implied or Assumed) Volatility Volatility Call Prices Put Prices Reflects expected variance in stock price - over option s lifetime - more variance potentially greater profits for buyers Volatility assumption (historical, expected, implied) - expressed as standard deviation in % form (e.g. 25%) - annualized

Volatility as Expected Variance in Underlying Stock Price Example: - XYZ currently at $60 - volatility assumption 25% In one year s time - XYZ to trade in range between $45 and $75 (± 25%) - 68% of time (1 standard deviation) - therefore, only 32% outside this range Bear this in mind - when assessing implied volatility levels - when pricing an option yourself

Measuring Changes in Implied Volatility

Vega (aka kappa or omega) Sensitivity of option price to change in volatility - generated by option pricing model - change expected in price for 1% change in implied - expressed in dollars/cents - theoretical in nature - implied up 1% - calls and puts up by vega amount - implied down 1% - calls and puts down by vega amount

Vega Example XYZ at $60-90 days til expiration XYZ 3-month 60 call (or put) at $3.30 - implied volatility = 25% - vega = 0.12 (12 ) Implied volatility up to 26% - call (or put) price up to $3.42 Implied volatility down to 24% - call (or put) price down to $3.18

Effect of Vega Any increase or decrease in option price due to changing implied volatility is in time value only In-the-money options - least time value small dollar and percentage changes At-the-money options - most time value largest dollar changes Out-of-the-money options - All time value largest percentage changes

Implied Volatility and the Option Marketplace

See the Future? Changing volatility not necessarily predictable May be influenced by (among other things): - news or rumors on underlying stock - world events (political or military) - volatility of broad market If you expect change in implied volatility levels - degree of change can surprise - timing of change can be swift Allow for changing volatility when buying/selling - experience is best guide

Rules of Thumb Buy low, sell high - when implied is low many investors buy - when implied is high many investors will sell - be aware of past implied volatility levels to judge - again, your call Buy rumor, sell fact - public rumors of upcoming news can drive implied up - when news is announced implied levels often drop When underlying drops, implied levels increase

Implied Volatility More than Variance? Implied volatility is a consensus - all market participants in the mix - some expecting/predicting underlying volatility change - supply and demand also a factor Supply and demand - more buyers than sellers prices up implied up - more sellers than buyers prices down implied down - possibly expected up/down trend for stock - not necessarily expecting volatility change for stock - this effect may be short-term, even intra-day

Implied Volatility and Your Position Because changes in implied affect time value - affects profits or losses during position s lifetime During lifetime, implied volatility increases - buyers may take earlier profits - sellers may feel pressured to stem losses During lifetime, implied volatility decreases - buyers may feel pressured to stem losses - sellers may take earlier profits At expiration, options have intrinsic value or not

Implied Volatility and Your Position Option buyers - expect favorable move in underlying - want implied volatility to increase - implied increase may offset time decay - exit plan: should allow for implied to drop Option sellers - expect favorable move in underlying - want implied volatility to decrease - implied decrease may add to time decay - exit plan: should allow for implied to rise

Implied Volatility and Your Forecast Include changing implied in your forecast? If wrong about stock move and right about implied - may not see losses, or - may lose less than you could have If right about stock move and wrong about implied - may not see profits, or - may see less profits than you could have

Long and Short Options Hypothetical Examples

Long Call Buy XYZ 3-month 60 call at $3.30 - XYZ at $60 implied volatility 25% After 1 month XYZ up to $65 - implied down to 20% = call at $5.80 - implied still at 25% = call at $6.20 - implied up to 30% = call at $6.50 Profit Increased Loss

Long Call Buy XYZ 3-month 60 call at $3.30 - XYZ at $60 implied volatility 25% After 1 month XYZ up to $65 - implied down to 20% = call at $5.80 - implied still at 25% = call at $6.20 - implied up to 30% = call at $6.50 Decreased Profit Increased Profit

Long Call Buy XYZ 3-month 60 call at $3.30 - XYZ at $60 implied volatility 25% After 1 month XYZ down to $55 - implied down to 20% = call at $0.40 - implied still at 25% = call at $0.75 - implied up to 30% = call at $1.10 Increased Loss Decreased Loss

Covered Call Sell XYZ 2-month 65 call at $1.50 - XYZ at $62 implied volatility 25% After 1 month XYZ still at $62 - implied down to 20% = call at $0.45 - implied still at 25% = call at $0.75 - implied up to 30% = call at $1.10 Increased Profit Decreased Profit

Covered Call Sell XYZ 2-month 65 call at $1.50 - XYZ at $62 implied volatility 25% After 1 month XYZ down to $57 - implied down to 20% = call at $0.02 - implied still at 25% = call at $0.10 - implied up to 30% = call at $0.15 Cover and Sell Another Call? Decreased Loss on Position

Covered Call Sell XYZ 2-month 65 call at $1.50 - XYZ at $62 implied volatility 25% After 1 month XYZ up to $67 - implied down to 20% = call at $2.90 - implied still at 25% = call at $3.20 - implied up to 30% = call at $3.60 Increased Profit on Position Decreased Profit on Position

Volatility Plays Profiting Simply from Changing Implied Volatility

Increasing Implied Volatility Buy straddle - XYZ at $60 - buy 2-month 60 straddle at $4.90 - implied at 25% After 2 weeks XYZ still at $60 - implied down to 20% = straddle at $3.45 - implied still at 25% = straddle at $4.25 - implied up to 30% = straddle at $5.15 Volatility Loss Time Decay Profit on Volatility Alone

Increasing Implied Volatility You might also consider: Long strangles (vs. long straddles) - cheaper to buy less risk - profits may be less bought out-of-the-money options - bigger move needed to profit from underlying price change if implied fails to increase For short-term trading - short time spreads - short butterflies

Decreasing Implied Volatility Sell straddle - XYZ at $55 - sell 1-month 55 straddle at $3.20 - implied at 25% After 2 weeks XYZ still at $55 - implied down to 20% = straddle at $1.80 - implied still at 25% = straddle at $2.75 - implied up to 30% = straddle at $2.70 Increased Profit Time Decay Decreased Profit

Decreasing Implied Volatility You might also consider: Short strangles (vs. short straddles) - Selling out-of-the-money options - less risk but less profit potential - bigger move needed to lose from underlying price change if implied fails to decrease Long time spreads Long butterflies and condors

Conclusion

Conclusion Understand ramifications of implied volatility - vega - implications for underlying price variance Be familiar with implied volatility behavior - factors that can affect it When establishing a position - know current implied level compared to past levels - account for favorable or unfavorable implied changes Expect the unexpected - implied levels can change abruptly and significantly

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