Trading Options: Advanced Concepts Lessons Learned from 30 Years of Investing and Options Trading

FPA IL CAP Conference 2014 Trading Options: Advanced Concepts Lessons Learned from 30 Years of Investing and Options Trading Russell Rhoads, CFA, Senior Instructor, Copyright (c) 2014 CBOE. All Rights reserved

Disclaimer & Disclosures Options involve risks and are not suitable for all investors. Prior to buying or selling options, an investor must receive a copy of Characteristics and Risks of Standardized Options. Copies are included with this presentation and may be obtained by contacting your broker, by calling 1-888-OPTIONS, or at www.theocc.com. In order to simplify the computations, commissions, fees, margin interest and taxes have not been included in the examples used in this presentation. These costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Multiple leg strategies may involve multiple commission charges. Investors should consult their tax advisor about any potential tax consequences. The information in this presentation, including examples using actual securities and price data, is strictly for illustrative and educational purposes only and is not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities or to provide investment advice. Supporting documentation for any claims, comparisons, statistics, or other technical data, will be supplied upon request. Past performance is not a guarantee of future results. Annualized returns cited might be achieved only if the parameters described can be duplicated and there is no certainty of doing so. CBOE, Chicago Board Options Exchange, Execute Success and VIX are registered trademarks and The Options Institute is a service mark of Chicago Board Options Exchange, Incorporated (CBOE). This presentation should not be construed as an endorsement or an indication by CBOE of the value of any non-cboe product or service used or described in this presentation. CBOE is not affiliated with FPA of Illinois. Copyright 2014 CBOE. All rights reserved. 2

Session Outline Volatility: The concept and three types What it says about stock price moves Probabilities of finishing and touching Using volatility to set price targets Income Generation: Portfolio Protection: Helping clients develop realistic expectations The real cost, the psychology and ways to lower the cost 3

Volatility The Concept Insurance Options Asset Value Stock Price Deductible Strike Price Time Time Interest Rates Int. Rates & Div. Risk Volatility = Premium = Premium Options are like insurance. Volatility corresponds to risk. 4

Types of Volatility Volatility means movement, but there are at least three ways to think of movement: Historical volatility Realized (or future) volatility Implied volatility 5

Historical Volatility Stock price action in the past High Volatility 38 36 34 32 30 28 26 Low Volatility 38 36 34 32 30 28 26 6

Realized Volatility Stock price action in the future (usually not the same as historical volatility) Also called future volatility Realized volatility is unknown today 7

Implied Volatility The volatility percentage that justifies the market price of an option The volatility in an option s price Rising implied volatility means that the market expects something to happen 8

Calculating an Option s Value XYZ stock 63.80 Strike Price 65.00 Days to Exp 45 Theoretical Value of 65 Call?? Interest Rates 0.7% Dividends -0- Volatility 30.0% Where does a trader get this number? 9

Calculating Implied Volatility XYZ stock 63.80 Strike Price 65.00 Days to Exp 45 Interest Rates 0.7% Dividends -0- Volatility?? Market Price of 65 Call 1.85 This is known. This is unknown. 10

Volatility Changes #1 Stock price volatility: Investor emotions rise and fall with economic, corporate and world news. Sometimes investors rush in or panic out of stocks. At other times they have nearzero anxiety. #2 Option implied volatility: As emotions rise and fall, the relative price that investors are willing to pay for options also rises and falls. #1 and #2 do not always rise and fall together. 11

Volatility Changes SPX H.V. & I.V. 12

The Bell Curve From Statistics 13

Volatility What it Means Stated volatility is the annual standard deviation 68% of the time in 1 year the price will be within 1 SD of today s price 95% of the time in 1 year the price will be within 2 SDs of today s price 99% of the time in 1 year the price will be within 3 SDs of today s price 14

Stated Volatility = Annual Std. Dev. S&P 500 (SPX) 1900.00 Days to Exp 365 Implied Volatility 12% Stock Price I.V. Days to Exp Days per year 100.00.12 365 365 = 228.00 15

Converting the 1-Year Std. Dev. S&P 500 (SPX) 1900.00 Days to Exp 60 Implied Volatility 12% Stock Price I.V. Days to Exp Days per year 100.00.12 60 365 = 92.45 16

Converting the 1-Year Std. Dev. SPX 1,900; Days 60; Stated Vol 12%; 1 SD 92.00 68% of the time in 60 days SPX will be between 1,808 and 1,992 ± 1 SD (1,900 92) (1,900 + 92) 95% between 1,716 and 2,084 ± 2 SDs (1,900 184) (1,900 + 184) 99% between 1,624 and 2,176 ± 3 SDs (1,900 276) (1,900 + 276) 17

1 S.D. Quick & Dirty The Straddle Buy 1 100 Call @ 3.35 & Buy 1 100 Put @ 3.30 10 8 6 4 2 0-2 90 95 100 105 110-4 -6-8 18

1 S.D. Quick & Dirty The Straddle Underlying Price 35 60 123 Strike Price 35 60 125 Days to Exp. 35 28 51 Int Rate/Div Yld 1.2/0 1.2/0 2.0/4.0 Volatility 35% 50% 43% 1 Std Dev 3.79 8.31 19.77 Call Price 1.53 3.34 6.80 Put Price 1.49 3.28 9.13 Straddle 3.02 6.62 15.93 Straddle / S.D.??? 19

1 S.D. Quick & Dirty The Straddle The at-the-money straddle price is 80% of 1 SD. This is based on implied volatility, which is determined by the supply and demand in the market. This calculation of SD is what the market thinks. 20

The Bell Curve What the bell curve tells you 68.2% of the time, a stock should land between up and down 1 SD at expiration 95% of the time, a stock should land between up and down 2 SD at expiration Conclusion: Options with strike prices 1 SD out of the money expire worthless 84% of the time. But how much do they increase in price 16% of the time? 21

The Bell Curve What the bell curve does not tell you What path does the stock take between now and expiration? How often is a standard deviation level violated? What happens once a standard deviation is violated? 22

Probabilities (probabilities of finishing ) 1 Close between up 1 SD and down 1 SD at exp 68% 2 Close between up 2 SD and down 2 SD at exp 95% 3 Close between up 3 SD and down 3 SD at exp 99% (probabilities of touching ) 4 Touch up or down 0.5 SD prior to expiration 99% 5 Touch up or down 1.0 SD prior to expiration 54% 6 Touch up or down 1.5 SD prior to expiration 22% 23

Probabilities 6 Touch up or down 1.5 SD prior to expiration 22% 7 Touch up or down 2.0 SD prior to expiration 7% 8 Touch both up and down 0.25 SD prior to exp 36% 9 Touch both up and down 0.50 SD prior to exp 14% 10 Close beyond 1.0 SD after touching 1.0 SD 58% 24

Using the Probabilities Probabilities #4 & #8, imply: If the underlying touches 0.25 SD, then there is a 64% chance the underlying will continue to 0.50 SD in the same direction without reversing to touch the 0.25 SD in the opposite direction. Therefore, there is a statistical advantage to following the trend when the underlying touches 0.25 SD. (At the least, this is a decision point.) 25

Using the Probabilities If you are bullish on a stock.. Wait for it to rise 0.25 SD, then buy it. You then have a 64% chance it will continue rising. If you buy a stock.. Down 0.25 SD is a logical level for a stop-loss. There is a 64% chance it continue falling. 26

Income Generation Sell options to generate income. Covered calls Cash-secured puts The hard question: If the market is efficient, why does selling options increase income? ANSWER: Selling options does not beat the market. It allocates part of the return to realized cash income instead of capital gains. 27

Income Generation CBOE created indexes to track option-selling strategies BXM: BXY: PUT: Own an S&P 500 Portfolio and Sell 30-day at-the-money SPX Calls Own an S&P 500 Portfolio and Sell 30-day 2% out-of-the-money SPX Calls Hold T-Bills equal to the S&P 500 Index and Sell 30-day at-the-money SPX Puts 28

CBOE S&P 500 BuyWrite Index $100 Invested in BXM and SPXTR June 30, 1988 July 31, 2014 1400 1200 1000 CBOE S&P 500 BuyWrite Index (BXM) 800 600 400 200 S&P 500 Total Return (SPXTR) 0 1988 1991 1994 1997 2000 2003 2006 2009 2012 Data Source: Bloomberg CBOE OPTIONS INSTITUTE 29

CBOE S&P 500 2% OTM BuyWrite Index $100 Invested in BXY and SPXTR June 30, 1988 July 31, 2014 1600 1400 1200 1000 CBOE S&P 500 2% OTM BuyWrite Index (BXY) 800 600 400 200 S&P 500 Total Return (SPXTR) 0 1988 1991 1994 1997 2000 2003 2006 2009 2012 Data Source: Bloomberg CBOE OPTIONS INSTITUTE 30

CBOE S&P 500 PutWrite Index $100 Invested in PUT and SPXTR June 30, 1988 July 31, 2014 1600 1400 1200 1000 CBOE S&P 500 PutWrite Index (PUT) 800 600 400 200 S&P 500 Total Return (SPXTR) 0 1988 1991 1994 1997 2000 2003 2006 2009 2012 Data Source: Bloomberg CBOE OPTIONS INSTITUTE 31

Income Generation Example 1 Stock Price 100.00 Days to Exp 90 Volatility 20% 1 Std Dev 10 (100 x.18 x 90 365) ½ SD OOM Call 105.00 Strike 2.05 (8.2% ROR) ½ SD OOM Put 95.00 Strike 1.85 (7.4% ROR) 32

Income Generation Summary Implied Volatility Est ROR Call Est ROR Put 20% 8.2% 7.4% 24% 10.0% 9.0% 28% 11.6% 10.2% Conclusion? Many people look for high volatility, because it makes more money. But these stocks have the same probability of moving twice as much. Stock picking is an art, not a science. 35

Protecting a Diversified Portfolio Your client has a $1,800,000 portfolio that closely follows the SPX now at 2,000 You are worried about a 15% market decline in the next 3-4 months. You want to limit downside risk and keep the upside. 36

Protecting a Diversified Portfolio Determine # of SPX contracts: Portfolio $Value to be Hedged Notional Value of Index Contract (Strike x $100) $1,800,000 2,000 x $100 =?? Buy 9 SPX Dec 2000 Puts @ $60.00 ($6,000/Contract) 37

Protecting a Diversified Portfolio $1,800,000 Portfolio SPX @ 2,000 Buy 9 SPX Dec 2000 Puts @ 60.00 Cost = 9 x 60 x $100 = $54,000 3.0% of portfolio value 1 SPX Put protects $200,000 Strike price is at the money 38

How the Protection Works Assume SPX at 1,700 (down 15%) Market is down 15% so portfolio is down 15% $1,746,000 stock portfolio now $1,484,000 With SPX @ 1,700 300.00 each 2000 Puts @ 300.00 x 9 x $100 = $270,000 Value of puts = 1,484,000 + 270,000 = 1,754,000 Total Portfolio = Market down 15%. You are down 3% 39

The Real Cost of Protection Imp. Vol. 4-mo ATM Put 4-mo 5% OOM Put 12% 2.7% 0.9% 16% 3.7% 1.4% 20% 4.6% 2.4% 24% 5.5% 3.2% 48% 11.0% 8.3% The cost of ATM protection rises linearly with rising implied volatility. The cost of OOM protection rises exponentially with rising implied volatility. 40

Unwilling to Pay for Puts? Sell equity calls to pay for index puts Sell near-the-money calls on stocks that you are willing to sell now. Sell out-of-the-money calls on stocks that you are willing to sell if price rises. Sell calls on part of a stock position if you want to lighten up or diversify. 41

Summary Volatility Income Historical, Implied, Realized Probabilities rule! Realistic expectations are key The goal is to get cash income (not to beat the market) Protection The cost is related to the level of implied volatility 42

Trading Options: Advanced Concepts THANK YOU FOR ATTENDING! Visit us at: www.cboe.com rhoads@cboe.com 43