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Here is your teacher waiting for Steve Wynn to come on down so I could explain index options to him.

He never showed so I guess that he will have to download this lecture and figure it out like everyone else. He was a nice host, though. And he seems very interested in math. A lot of things going on in this large curved building behind me seemed to have a connection to math.

Advanced Options Trading Strategies


... the game is on
(c) 2006-2011, Gary R. Evans.

Reading the Options Chain


Expiration date

IBM's stock price

You can buy call option IBMJRX for 15 cents, which give you the right to buy IBM for 90 between g y now and Oct 20.

In the Money

Out of the Money

At the Money Out of the Money


Source: http://finance.yahoo.com options quotation for October 11, 2006

In the Money Volume & Open Interest

Buying and Selling Options Online


Suppose I want to buy the October 85 call marked below in the diagram cut from my Ameritrade account. To buy this option if I submit a market order it will be bought at ASK (1.10). But look at the spread between BID and ASK. I really should submit a limit order, though, at ASK or below, although if it is not y , g , , g at ASK it may not get executed. One option is to submit a limit order between BID and ASK. Another option is to target an even lower price, put in a day order and hope that the stock and the option dip down and the order executes. On the next screen, I decide to buy 5 contracts ( (500 shares) with a limit ) order. Note the Buy / Sell / Open / Close / Exercise buttons and make sure I explain them

Buy to Open to buy a call or put. Sell to Close to sell the call or put that you already own. Sell to Open to write a call or put. Buy to Close to offset (cancel) a call or put that you have written. Exercise to exercise an in-the-money option at any time.

Enter these

Pointers about option trades


There is often a large spread between bid and ask, and this really cuts into option trading profits.
conversion to electronic trading from open outcry may remedy this

Never, ever, use a market order for an option trade.


or you may be real surprised at the price you pay.

Before trading an option, always check open interest and volume for liquidity. O Once an option goes into the money, it can be difficult to ti i t th b diffi lt t decide when to sell it.
take profits now or hope that it goes higher and pray that it doesn't fall back out of the money.

Simple option strategies .. calls


Writing a call
covered (you already own the stock)
reduces risk locks in return

naked (you don't own the stock)


collecting fees and gambling in no price rise in stock

Buy a call
gambling that the price will rise near or out of the money: high leverage, high risk deep in the money: lower leverage, lower risk

Simple option strategies .. puts


Writing a put
short-covered (short on stock) h t d( h t t k)
hedging, locking (same as a call)

naked (no stock position)


gambling on no price decline

Buying a put
gambling price will fall excellent hedge for a long position in stock or related asset

Hedging with options


Hedging with options is easy. Normally, if you are long in a g g p y y, y g stock and if you want to protect yourself against a large loss, you can buy an out-of-the-money put. This, of course, will lower your yield if you make a capital gain on the stock. The lower the strike price of the put, the cheaper the insurance, but the greater the loss if the stock falls. There is a tradeoff between cost of insurance and the degree of protection. Hedging short works the same way. If you are short in a stock, you hedge by buying an out of the money call.

Example
Suppose you owned 500 shares of IBM. When IBM was trading for $93.30, the following put options were available (6 week expiration): k i ti )
Strike Put 85 90
+IBMXQ +IBMXR

Bid 0.15 0.65

Ask 0.20 0.70

Last 0.20 0.70

Chg 0 0

Vol 18 153

Open Int 4,900 2,658

Buying 500 90 puts at ask would cost you $350, but you would lose no further money if IBM fell below $90. Buying 500 85 puts would cost you $100 and protect you at $85. Of course you can also protect yourself with stop-loss orders, although execution of those at the limit price are not guaranteed.

The all-important premium on OTM options allpremium


The premium for an in-the-money option converges to zero as the option approaches expiration. pp p The premium of an out-of-the-money option can be thought of as simply the price of the option because the option has an intrinsic value of 0 at the moment. The premium for either is a function of 1. 2. 3. Time to maturity (shorter is smaller) The degree to which the option is in the money (more is smaller) The underlying stock's volatility (greater is larger)

Premium Behavior
The premium on an option is determined by the three components listed on the last slide, (1) the volatility of the stock and the market in general, (2) spread from the strike price (whether in the money or out), and, (3) especially for out-of-themoney options, the time before the option expires. It is possible to segregate these three in theory and empirically and the ability to do so is essential for advanced options trades.

Spread
10/9/08 DIA at 91.55 DIA Nov Call Ask Strike Ask Premium 75 17.10 0.55 80 12.25 0.70 90 4.45 2.90
Closer is greater

Time
9-Oct-08 DIA at 91.55 DIA 94 Call Ask Oct 2.37 Nov 5.10 Dec 5.90 Mar 7.60

More distant is greater

Advice: Design and use your own models!!

Note: Premiums were unusually high in Oct 08 because of volatility in the markets.

My approach
Name:Gary Evans Date:3/8/2011 Put Option Price Calculator Daily Volatility Stock symbol: Put option: Date Today: Expiration Date: DTM: Stock Price: Strike Price: Daily Volatility: Interest Rate: Time: d1 Numerator: Duration Volatility: N(-d1): N(-d2): Option Price: Option Premium: TLT Jun 91 5/12/2010 6/19/2010 38 92.72 91.00 0.0070 0.010 45 0.01996 0.04696 0.3354 0.3527 0.96 0.96

I generally have my own way of doing things, a little different from the book and the standard ways. Generally I dont use Greek-based models for reasons that I will explain when we get to the Greeks. Instead I use dynamic sensitivity models, which I will explain here in part and later in more detail. I always use daily volatility measures (because my trades are generally shortterm) and I use my own variation of the Black-Scholes model. We will learn both of course.

Version 2.2 May 11, 2010

Use <F9> to manually calculate this worksheet.

Strangle Option Value Calculator


Name: Date: Stock Name: Call Symbol: Expiration Date: Stock Price: Call Daily Volatility: Interest rate: Gary R. Evans 2/11/2011 DIA Feb 122.75

Stock Symbol: DIA Put Symbol: Feb 121.75 DTM: Days Time: Put Daily Volatility: 8 5 0.00600 PUT 121.75 0.00546 0.01342 0.34197 0.34691 0.37 0.37

2/19/2011 122.400 0.00470 0.010 CALL Strike Price: 122.75 -0.00272 0.01051 0.39795 0.39390 0.36 0.36 0.3980 0.74 1.03

My strangle calculator that I use all of the time (before and strangle or straddle trade). trade) I also calculate historical volatility many different ways:
Date: 1/28/2011 Symbol: DIA Abs DEL LN Plus 1 0.9997492 0.9989962 1.0005857 0.9907570 0.9959398 1.0003390 1.0005929 0.9954167 Average: Days: Volatility: Max: Min: StdDev:
Daily Volatility

Strike Price: d1 Numerator: Duration Volatility: N(-d1): N(-d2): Option Price: Option Premium: Delta: Profit/Loss: Profit/Loss %:

d1 Numerator: Duration Volatility: N(d1): N(d2): Option Price: Option Premium: Delta: Position Cost/Value: Original Cost:

-0.6580 -0.29 -39.61

Completed and tested January 11, 2009.

0.0002508 0.0010038 0.0005857 0.0092430 0.0040602 0.0003390 0.0005929 0.0045833


0.02500

-0.00125 64 0.00409 0.01573 -0.02252 0.00620

Original Stock Price: Desired Percent %: New Stock Price:

0.00 0.000 0.00

0.02000

0.01500

0.01000

0.00500

0.00000

Time Decay
1.60 1.40 1.20 1 20 1.00 0.80 0.60 0.40 0.20 0.00
33 32 31 30 29 28 27 26 25 24 23 22 21 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1

This shows the actual projected time decay of a March 75 DIA call option, purchased for $1.51, when DIA was trading at $72.15 (implied daily volatility at 0.0156), calculated using an option calculator. calculator This assumes no change in DIA price and no change in volatility.

Time Decay
tp = d tpd

m = d 30 55 d .

TD = f
6

dtm

The standard deviation of the growth rate of any stock for a period measured in days is equal to the daily standard deviation times the square root of the days in the time p y period. For example, the monthly standard deviation is equal to about 5.5 times the daily standard deviation. This implies that the time decay of an option premium (especially otm) will be a function of the y p y y decay represented by daily taking the square root of the days remaining to maturity, as shown in the graph on the left.

0
30 29 28 27 26 25 24 23 22 21 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1

VIX: The CBOE Volatility Index


The higher this measure the higher th hi h the volatility premiums l tilit i on puts and calls.
ETNs: VXX, VXZ (iPath) VIXM, VIXM VIXY (P h (Proshares) ) (delta ETFs holding positions in S&P500 futures contracts)

The VIX is a volatility measure of the S&P500 index based upon S&P500 stock index options prices. VIX futures contracts are offered by the CBOE. To see how the VIX is calculated, on Google find vixwhite.pdf
Graph source: finance.yahoo.com

VXX as it tracks the VIX Index

VXX is the iPath short-term futures ETN which is invested in the first two near-term futures contracts of the CBOE VIX futures contract, which in turn is linked to the actual VIX index, which is calculated using put and call prices for the CBOE SPX benchmark index, which is a synthetic stock. The options are European style and futures are cash settlement.
Graph source: finance.yahoo.com

The Impact of Volatility


Put Option Price Calculator Daily Volatility Stock symbol: TLT Put option: Oct 106 Date Today: 8/25/2010 Expiration Date: 10/16/2010 DTM: 52 Stock Price: Strike Price: Daily Volatility: Interest Rate: Time: d1 Numerator: Duration Volatility: N(-d1): N(-d2): Option Price: Option Premium: 108.14 106.00 0.0117 0.010 52 0.02142 0.08437 0.3998 0.4327 2.57 2.57
3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00

Note: This is mapped in TLT Volatility in Finance>Volatility Calcs

Scenario: 20 days have passed, leaving 32, no change in price, so the graph above shows the sensitivity to volatility alone.

The VIX and Strangles


If you are in a strangle, especially on an index ETF like DIA, and the VIX , does this after you have taken the position, you will make money.

On the other hand, if you make any kind of option trade, straddles, strangles, or just buying puts or calls, when the VIX is this high, you are paying a very large premium and might lose when the VIX falls. This might be a good time to write covered calls if the volatility is not due to market stress.

The 85 call option ($1.10)


This standard textbook approach to what happens to a call option when it goes above the strike price is misleading. As the stock price approaches the strike price, you can still make money on the option even if it doesn't go above the strike price, let along the break-even price. This is especially true if there is plenty of time to maturity. The price of the option can rise just because general volatility rises (as measured by the VIX) or if specific volatility rises in the stock represented by this option because of an event (like an earnings report) or for any other reason that will affect immediate daily volatility.
8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 -1.00 -2.00

Strike Price: 85.00

Break-even Price: 86.10

82

83

84

85

86

87
Stock Price

88

89

90

91

92

Option value

Profit

10

Notes on options strategy


The higher the Volatility of a stock, the higher the premium on the options. When you write a covered call or put, you pocket the money. Writing covered calls works well with high volatility stocks, very well sometimes. Straddles and Strangles are bets on volatility, not on the stocks alpha Generally you are betting stock s alpha. either on an extreme move (news base) or a rise a volatility (and one can cause the other). You are always fighting time decay with spec option trades.

11

Maderas Golf Course, San Diego County, 9th hole. Your teacher brilliantly birdied this hole. He triple-bogied the one in the background. You should play golf to understand options because you learn how things can go from really good to really bad really quickly

Option advanced strategies p2


2002-2011, Gary R. Evans. May be used for educational purposes only without express permission of Gary R. Evans.

Example: Options probability information using a technique that we have used.


This graph from market open March 10, 2011, shows current price of SPY (at that moment) and probability array of SPY being above (call) or below (put) the at an 86% probability using an annual volatility estimated at 20.43% (which implies DV 0.0126). Graph here is only showing the left side. Other probabilities shown on the bottom

Source: TDAmeritrade ThinkorSwim interactive strategy, my account.

Three Postulates that really matter


1. A call or put, randomly selected and then purchased, has an expected value equal to its price (excluding transaction charges and B/A spreads) ...
... therefore the purchase of a call is not the same as the poor mans way of investing in the stock because ...

2.

Although the stock may have a higher expected value (a positive alpha) and is therefore a positive-sum game, a call or put option on the stock is a zero-sum game and with transactions fees and B/A spreads is a negative-sum game ...
... although if the option is used heavily for hedging, which is possible for some heavily-held stocks and ETFs, in that case the spec position might actually be a positive-sum gain as it theoretically is for futures ... ... and this is a variation of an efficient markets hypothesis.

3.

Although this negative- or zero- sum feature is probably more or less true for the market as a whole, it is not true for every option in the option chain of every stock with options
bias is everywhere, so the secret is to discover the bias and act on it ... and this almost always requires the use of a model

Postulates 1 & 2

On March 9, 2011 at 11:52 AM PST, SPY Best Ask was 132.49, and this (above) was the May 21 Call option chain at that moment, with 73 days to expiration. Consider the 135 Call and the 137 Call (highlighted). What does postulates 1 & 2 say about them? Both represent a zero-sum game, as do all of the other options on this page, and as do all other put and call options in other months for this stock!! What exactly does that imply?

Interpretation of P1 and P2: Strong EM hypothesis: The expected value of the bet (area under line) is equal to the cost of the bet. Weak EM hypothesis: The expected value of all bets, whatever they are, are equal. , q Important note: if we can demonstrate that the weak is false, then the strong is false.
COST: $2.64 Expected Value of the bet: $2.64 $2 64

132.49 COST: $1.81

135

Expected Value of the bet: $1.81

132.49

137

Postulate 3 It tends toward efficiency (weak or strong) for all, but not for the components.
Basically, weak EMH is going to fail because there is no way that even arbitrage will force every component of an option chain to produce an expected ROI. But if Postulate 3 is true, then the bias that is found in each individual option is as likely to be harmful (negative sum) as helpful (positive sum). Postulate 3 is essentially untestable, but we have to assume that it is true. Therefore we have to use some kind of model to find the bias!

132.49
All calls and puts in all of the option chains for SPY, when considered, must fit this distribution for even the weak EMH to be true for individual stocks.

Where are we going with this?? Hint: P1 and P2 imply that (a) given that core standard deviation must be the same (b) then implied and all actual volatilities must therefore be the same.

Our 2011 sample candidate - IWM


IWMunadjustedsharevalue
84.00

82.00

80.00

78.00

76.00

74.00

72.00

IWM Daily LN growth

0.0300

0.0200

0.0100

0.0000 0 0000

Two volatility estimators for IWM, 60 day, graph shown with 5 DMA. DMA.

-0.0100

-0.0200

-0.0300

IWMDailyABSCGRVolatility y y
0.03000

0.02500

0.02000

0.01500

0.01000

0.00500

0.00000

5-day VIX

Above is the Apr 16 option chain at the moment when IWM was 80 26 This was on 80.26. a bad day when the Dow was down about 200 points and the Russell 2000 was down 1.68% at this moment.

Open March 10, 2011

Options strategies: Straddles


When you do a straddle, you buy a call and a put for a single strike price that is near the money, in the money for one option and out of the money for the other. For our IWM example, when IWM was selling for $80.26 that might be the April 16 82 Call ($2.72 itm) and the 80 Put ($2.90 otm). The cost of the position is $5.62 net debit. The carry for this contract are the transactions fees both ways and the B/A, spread, fortunately only a penny per share each side..

A portion of the TDAmeritrade screen on which this order would be placed.

The 80/80 straddle: Calculation of Implied Daily Volatility (IDV)


Use <F9> to manually calculate this worksheet.

Calculation of Option Price Using Estimated Volatility


Call Option Price Calculator (Daily Volatility) Stock symbol: IWM Call option: 1-Apr Date Today: 3/10/2011 D t T d Expiration Date: 4/16/2011 DTM: 37 Stock Price: Strike Price: Daily Volatility: Interest Rate: Time: d1 Numerator: Duration Volatility: Delta N(d1): N(d2): Option Price: Option Premium: 80.26 80.00 0.01099 0.010 37 0.00426 0.06685 0.5254 0.4988 2.31 2.05

Strangle/Straddle Option Value Calculator


Name: Date: Stock Name: Call Symbol: Expiration Date: Stock Price: Call Daily Volatility: Interest rate: Gary R. Evans 3/10/2011 Russell 2000 Apr 80

Stock Symbol: IWM Put Symbol: Apr 80 DTM: Days Time: Put Daily Volatility: 37 37 0.01580 PUT 80.00 0.00427 0.09611 0.48228 0.52060 2.90 2 90 2.90 -0.5177 0.00 -0.07

4/16/2011 80.260 0.01310 0.010 CALL Strike Price: 80.00 0.00427 0.07968 0.52135 0.48958 2.72 2 72 2.46 0.5214 5.62 5.62

Strike Price: d1 Numerator: Duration Volatility: N(-d1): N(-d2): Option P i O ti Price: Option Premium: Delta: Profit/Loss: Profit/Loss %:

d1 Numerator: Duration Volatility: N(d1): N(d2): Option P i O ti Price: Option Premium: Delta: Position Cost/Value: Original Cost:

Version 2.1 - May 11, 2010.

Completed and tested January 11, 2009.

Original Stock Price: Desired Percent %: New Stock Price:

80.26 0.000 80.26

Note: IDV for Call does not match IDV for Put and neither matches historical IDV. Why not, and what opportunity does this imply?

Options strategies: Strangles


When you do a strangle, you buy a call and a put for a different strike prices that are near the money (although not necessarily closest to the money the farther away, the cheaper the bet and typically out of the money for both options. For our IWM example, when IWM was selling for $80.26 that might be the April 16 82 Call ($1.72 otm) and the 78 Put ($2 12 otm) ($2.12 otm). The cost of the position is $3.84 net debit.
A portion of the TDAmeritrade screen on which this order would be placed.

The 82/78 strangle: Calculation of Implied Daily Volatility (IDV)


Use <F9> to manually calculate this worksheet.

Calculation of Option Price Using Estimated Volatility


Call Option Price Calculator (Daily Volatility) Stock symbol: IWM p p Call option: 1-Apr Date Today: 3/10/2011 Expiration Date: 4/16/2011 DTM: 37 Stock Price: Strike Price: Daily Volatility: Interest Rate: Time: d1 Numerator: Duration Volatility: Delta N(d1): ( ) N(d2): Option Price: Option Premium: 80.26 82.00 0.01099 0.010 37 -0.02043 0.06685 0.3800 0.3548 1.43 1.43

Strangle/Straddle Option Value Calculator


Name: Date: Stock Name: Call Symbol: Expiration Date: Stock Price: Call Daily Volatility: Interest rate: Gary R. Evans 3/10/2011 Russell 2000 Apr 82

Stock Symbol: IWM Put Symbol: Apr 78 DTM: Days Time: Put Daily Volatility: 37 37 0.01648 PUT 78.00 0.02959 0.10024 0.38393 0.42272 2.12 2.12 -0.6161 -1.78 -46.28

4/16/2011 80.260 0.01250 0.010 CALL Strike Price: 82.00 -0.02043 0.07603 0.39410 0.36517 1.72 1.72 0.3941 3.84 5.62

Strike Price: d1 Numerator: Duration Volatility: N(-d1): N(-d2): Option Price: p Option Premium: Delta: Profit/Loss: Profit/Loss %:

d1 Numerator: Duration Volatility: N(d1): N(d2): Option Price: p Option Premium: Delta: Position Cost/Value: Original Cost:

Completed and tested January 11, 2009.

Version 2.1 - May 11, 2010.

Original Stock Price: Desired Percent %: New Stock Price:

80.26 0.000 80.26

Note: IDV 82 Call = 0.01250 80 Call = 0.01310 78 Put = 0.01648 80 Put = 0.01580. ????

Volatility sensitivity analysis for the 82 call option ...


$4.00 $3.50 $3.00 $2.50 $2.00 $1.50 $1.00 $1 00 $0.50

Original straddle was on a Thursday March 10. How will the 82 call look on Monday at these various volatilities? We paid $1.72 for this call. p $ 4-day time decay $1.72 - $1.58 = $0.14 If the call goes to estimated volatility, the call will be worth 1.58 $1.32, a loss of $ 0.40.
1.14 0.72 0 2 0.32 0.04 2.03 2.48

3.39 2.94

$0.00 0.0025 0.0050 0.0075 0.0100 0.0125 0.0150 0.0175 0.0200 0.0225

When do you do straddles and strangles?


You are betting on volatility, not the alpha (you dont care whether the stock rises or falls). Because of the short duration of your bet, timing is critical (time decay). You are betting on one or more of three variables: 1. A rise in this stocks volatility. 2. A news event that causes a discontinuity. ( y y 3. If IDV for both is well below EDV (and you are confident you have good numbers, which is a tall assumption), you bet on the spread widening or if IDV is a lot fatter than EDV, you may not make this bet even if your reason for betting is number 1 or 2. In our example, we might not make the bet without weighing this.

Straddles & Strangles can pay off because of Discontinuities

JWN announces that sales are going better than expected.

The VIX and Strangles


If you are in a strangle, especially on an index ETF like DIA, and the VIX , does this after you have taken the position, you will make money.

On the other hand, if you make any kind of option trade, straddles, strangles, or just buying puts or calls, when the VIX is this high, you are paying a very large premium and might lose when the VIX falls. This might be a good time to write covered calls if the volatility is not due to market stress.

My Sep/Oct 2008 DIA Strangle


In the volatile and dangerous market of Sep/Oct 2008, when the DJIA fell for every day in October until its spectacular 938 point rally on Monday, October 13, I put a strangle on the DIA tracking stock (which tracks the DJIA at one-tenth the value). I calculated the monthly standard deviation for the DIA CGR going back four years at 0.0301 (3%). On Sep 25, when DIA was at 110.27, I bought 120 calls for $0.32 each and 97 puts for $0.63 each, same number of contracts. The calls were 1,000 Dow points otm, or 9%, and the puts were 1,300 Dow points otm, or 12%. Basically I was 3 sigmas away on the calls and 4 sigmas on the puts. But the VIX was climbing to record territory and I knew that historical sigmas were not relevant. On Sep 29 the DJIA plunged and I sold half of my put position for $1.94. The next day I sold my calls for $0.33, a once cent profit, which had risen despite the fall in the DJIA because the VIX had risen. On the same day I sold my remaining puts for 1.28. I should have stayed in the second half of the put position. They went to $13 on 10/10.