Price and Volatility Analysis for Index Options Trading

Price and Volatility Analysis for Index Options Trading

Topics Why I trade options (instead of the underlying) How volatility affects options pricing Volatility characteristics and analysis techniques Using volatility analysis to drive options trading Sample trades, methods and guidelines

Why I trade options Options instruments exhibit unique characteristics Options are a wasting asset Options present an asymmetric risk profile Option pricing is highly dependent on expected volatility I use combinations of options to construct positions with a superior risk/reward profile relative to the underlying. I do not trade vertical credit spreads, iron condors or naked put options Note: Option price behavior is non linear relative to the underlying security. Position and portfolio risk management require robust analytical tools.

Why I trade index options Liquidity Event/tail risk Selection Risk

Buy a Call Buy call, near ATM Profit Loss

Call purchase vs long stock

What Factors Determine the Price of an Option? Time to expiration Distance in or out of the money Anticipated or Implied Volatility

In Order of Importance These Options Pricing Factors Are: 1. Anticipated or Implied Volatility 2. Anticipated or Implied Volatility 3. Anticipated or Implied Volatility

What About The Greeks? Delta Gamma Theta Vega Rho ETC

What Happens When I Explain the Greeks in a 45 Minute Webinar??

Real World Impact of Volatility August 17, 2015 SPX = 2102 Nov. 1500 Put Option = $1.00 August 24, 2015 SPX = 1893 Nov. 1500 Put Option = $23.00 Delta of option: -0.89 Vix = 13 Vix = 39 Option Price Change = $22.00 Dollar change from Delta = $ 1.86 Dollar change from Volatility = $20.22

Volatility Behavior is More Predictable Than Price Mean Reverting Moves Inversely to Price Stable Put Call Skew

The Term Structure of Volatility

The VXV The VXV is a 90 day VIX Observing the ratio of the VIX to the VXV can provide shorthand indicator of contango or backwardation in the volatility term structure.

Using Volatility to Construct a Trading Strategy Each option has a unique sensitivity to volatility Combinations of options or spreads aggregate those sensitivities and may in total be net long or net short volatility A simple volatility sum may be misleading due to shifts in the slope of the term structure.

Using Volatility to Construct a Trading Strategy Mean reversion: Use short volatility positions when volatility is elevated Inverse to Price: Use short volatility positions above the market and long volatility positions below the market Term Structure: Use vertical positions when in contango and horizontal (calendar) positions when in backwardation.

Trade Examples My least favorite trades

Covered Call Profit Loss Bought 100 shares in underlying equity Sold 1 ATM call

Naked Put Profit Loss Sell uncovered put

Trade Examples Short Volatility Trades

Call Ratio Spread Vertical Spread Short Volatility Upside price capture without downside risk Can be done to collect premium as well Placed using term structure and price trend analysis

Position Example: Bull Call Spread 1 x 3 Above the Market Profit Loss Lower Price of S&P 500 Index At expiration profit zone Higher 30

Position Example: Bull Call Spread 1 x 2 Above the Market Profit Loss At expiration profit zone Lower Price of S&P 500 Index Higher 31

Trade Examples Long Volatility Trades

Put Calendar Spread Horizontal Spread Long volatility captures volatility expansion during erratic price movements Best in term structure backwardation Can be used to collect premium as well

Diagonal Put Calendar Spread Sell 1 put out of money, below the market Buy 2 puts later in year, further out of the money Profit Lower Price of S&P 500 Index Higher 36

Put Diagonal Spread Volatility change = +10 Sell 1 put in near month Buy 1 put one month later and ~250 points lower Volatility change = +5 Volatility change = 0 Profit Loss Price of S&P 500 Index 37

Conclusions Options can be a viable substitute for underlying assets in many trading environments Option Pricing is highly dependent on implied volatility Volatility exhibits extremely reliable patterns and characteristics Understanding volatility behavior can add a significant edge in options trading Analyzing the term structure of volatility is critical to options trade selection

Ed Walczak Sr. Portfolio Manager Catalyst Mutual Funds Catalyst Hedged Futures Strategy Fund - HFXAX Catalyst Hedged Commodity Strategy Fund CFHAX www.catalystmutualfunds.com