OPTIONS TRADING AND VOLATILITY Presented by Jason Ayres DMS Montréal Exchange Instructor In partnership with BMO InvestorLine 1
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Agenda Complexities of options pricing Why volatility is important Offsetting volatility with debit spreads Selling volatility 3
The Complexities of Option Prices Stock price Strike price Time Interest rates Dividends Volatility Adjustment for risk 4
Why is Volatility Important? Adjustment for risk Implied volatility will be impacted by Company earnings Pending announcements or mergers Economic or market environment 5
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
Normal Distribution Bell Curve $45 68.2% $55 $30 $35 $40 $45 $50 $55 $60 $65 $70 7
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
Expanding Implied Volatility $42 68.2% $58 $30 $35 $40 $45 $50 $55 $60 $65 $70 9
Contracting Implied Volatility The environment changes creating a period of less volatility Volatility will contract adjusting the price of options 10
Contracting Implied Volatility $47 68.2% $53 $30 $35 $40 $45 $50 $55 $60 $65 $70 11
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
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
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
Offsetting Volatility Debit Spreads 15
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
Bull Call Spreads Bullish outlook Buy 1 call option Sell 1 call option with a higher strike Same stock or ETF Same expiration 17
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 $0.95 18
Bull Call Spread Option Selection BUY SELL 19
Bull Call Spread Risk Graph ABX Break Even = $19.00 + $0.95 = $19.95 $205.00 $0.00 $17.00 $18.00 $19.00 $20.00 $21.00 $22.00 -$95.00 20
Bull Call Spread on ABX Maximum profit = spread - debit $3.00 $0.95 = $2.05 Break even = purchased strike + debit $19.00 + $0.95 = $19.95 Maximum loss = net debit $0.95 21
Bear Put Spreads Bearish outlook Buy 1 put option Sell 1 put option with a lower strike Same stock or ETF Same expiration 22
Selling Volatility Selling Covered Calls and Puts 23
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
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
Low Volatility Example Buy 1,000 shares of EnCana (ECA) 1,000 x $18.00 per share = $18,000.00 1 month $19.00 call trading at $0.30 Implied Volatility is 33% Sell 10 calls (covered) You collect $300.00 (1.6%) for the obligation to sell the 1,000 shares of ECA over the next 1 month at $19.00 26
Higher Volatility Example Buy 1,000 shares of EnCana (ECA) 1,000 x $18.00 per share = $18,000.00 1 month $19.00 call trading at $0.95 Implied volatility increases to 70% Sell 10 calls (covered) You collect $950.00 (5%) for the obligation to sell the 1,000 shares of ECA over the next 1 month at $19.00 27
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
Low Volatility Example Barrick Gold Corp (ABX) is trading at $19.00 1 month $18.00 put is trading at $0.50 Implied volatility is 40% Sell 10 puts (uncovered) You collect $500.00 for the obligation to buy 1,000 of ABX over the next 1 month at $18.00 3 % in 1 month 29
Higher Volatility Example Barrick Gold Corp. (ABX) is trading at $19.00 1 month $18.00 put is trading at $0.80 Implied volatility increases to 62% Sell 10 puts (uncovered) You collect $800.00 for the obligation to buy 1,000 shares of ABX over the next 1 month at $18.00 4.5% in 1 month 30
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
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 www.m-x.ca and www.m-x.tv 32
Questions? 33
Thank you! 34
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