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The Option Pit MethodOption PitOption Pit Boot Camp

The Option Pit MethodFor trading options

Option Boot Camp- The Option Pit Method

The Option Pit method usesPosition StructureEfficient use of CapitalRisk Management

Structure positions that have edge but keep the risk relatively low.To do that traders need to know the fundamentals to identify market conditions

The Option Pit Method

The volatility is in the toilet. - Mark Sebastian numerous times on Bloomberg News

If you think education is expensive, try ignorance. Derek Bok, former Harvard President

Option Boot Camp- What you will learn

What makes an option move? Intent!Inputs and GreeksUnderstanding Volatility ConditionsTrade selectionWe will cover spreads, collars and butterfliesUse the Greeks to manage your book- Intro to risk management

Boot Camp I- What you will learn

The Option Pit Input Circle

The Option Model

The Greeks Delta, Gamma, Theta, Vega

The Option Pit Input CircleMoneyness- Which Strike?Time to expiration How Far?Time Decay- positive or negative decayVolatility How much does the underlying move?Direction of the Underlying- up, down or nowhere fast

The Option Pit Input CircleWhat makes an option move?

Moneyness- Which StrikeAre the options big dollars or small dollars?As the strike price goes from lower to higherCalls will go from ITM to OTMPuts will go from OTM to ITMThe more ITM the strike price is, the more it is sensitive to changes in priceThe further out in time we go, the more the strikes act alikeThe higher the volatility, the more the strikes act alikeThe more ITM the option is, the more cost of carry issues come into play

Direction of the Underlying- PricePrice of the underlying is one of the inputs that most traders getWhen price goes up, calls gain valueThe lower the strike price, the more value it will gain from priceThe further out in time one owns the option, the less sensitive to price the options will beThe higher volatility of the underlying, the less sensitive to price the option will be

Direction of the Underlying- Price

When price goes down, puts gain valueThe higher the strike price, the more value it will gain from priceThe further out in time one owns the option, the less sensitive to price the options will beThe higher volatility of the underlying, the less sensitive to price the option will be

Time to Expiration- Expiration DateTime is money!

Small price changes will have little effect on the price of the optionCalls and put at all strikes will all head towards being ATM optionsOptions become more sensitive to changes in a stocks volatilityMore time, more issues with cost of carry (dividends)

Time Decay- Long or Short OptionsDoes the position lose value every day just by showing up or does it make you money?

-That is time decay

Long options have negative time decayShort option have positive time decay

VolatilityHow much does the underlying move?That is volatilityOf all the inputs in the model, this is the only one we really dont knowInterestingly enough, the model is trying to use forward volatilityEnds up using implied volatilityAs volatility increases, the value of all options increasesBuying insurance before or after a hurricane

Add the inputs togetherOnce all the inputs are accounted for, investors can start to generate an idea for a positionSome of the inputs are easy and some are much harderLook at risk now for the goodies you get versus the risk of the inputs changing

Pricing Model Uses InputsInputsTheoretical Value

What is a Normal DistributionAssumes stocks have an equal chance of moving up or down at any given time

VarianceWhen a distribution moves within a normal range, it is called a varianceA variance represents how much we would expect the data set to vary most of the timeWe use variances all the time as traders

What is VolatilityVolatility is another word for the statistical term variance over a specific range of timeRepresents an expected range for a stock or index on an annualized basis regardless of directionA 75 dollar stock that has a volatility of 20%In a given year, the stock is expected to move 15 dollars OR LESS about 2/3 of the time.In a given year, the stock expected to move 30 dollars OR LESS 95/100 of the time

Standard DeviationStandard Deviation: annualized volatility over a non-annual period of time

volatility*sqrt(days/year)

Allows traders to connect annualized into volatility into short periods of timeAllows for use to analyze earnings, events, low and high vol, you name it

Standard Deviation CalculationSPX midday Dec 9th 2014

Volatility for the Jan Ord is 16.66Expiration is in 37 days

So .166 x (37/365)sq rt = .0522041 x .052 = $107 for roughly 2/3 of the time

What is VolatilityThere are 3 kinds of volatility we will talk about:Historical Volatility

Forward Volatility

Implied Volatility

Forward VolatilityHow much is a stock moving from RIGHT NOW until EXPIRATIONImpossible to gaugeWe are trying to be fortune tellersCan use estimates like volatility chartsInvolves overnight riskWeekend riskIntraday risk

Historical VolatilityHow much has the stock moved over the last time periodHigh-Low VolatilityIntraday RangeClose CloseOpen Open10 day, 20 day, 30 Day, 90 day, 180 dayI like 20 day because it is has some noiseTracks 30 day IV

Implied VolatilityWe will dig into this more, but:Implied Volatility is actually an OUTPUTBecause it is an OUTPUT, and we do not know what the stock's volatility is, Implied Vol is actually an outputGarbage in, Garbage out

Implied VolatilityIssues with implied volatility:Because of market fear of a major increase in forward volatility, option implied volatility is often too high relative to what ends up being the calculated forward volatility (we will see this in the term structure)Typically believed to be about 3-4% too highBecause an instrument may have many strike prices, hedges or speculations can still be wrongThe BID-ASK spread in options can throw off IV

ReversionIn any given year, an event can cause a security to have an outlier volatilityBut, over time, volatility of any asset will tend to mean revertThis means that it will hover around its averageThis applies to all types of volatility that can be measuredHV will revert to its meanIV will revert to its meanFV will overtime BE the mean

Understanding risk in terms of inputsThe GREEKS ARE AN OUTPUT of a pricing model not an inputAs the 5 factors change, so do the GreeksThe Big Greeks Are:DeltaGammaVegaTheta

Easy Greeks

Using the Greeks as a Risk Management Tool

How to get to P/L

Option Pit FLOW CHART

Easy Greeks- Delta

Easy Greeks- DeltaThe way an options price will move with the underlying price, sometimes called correlationA Positive Delta will move just like stockwhen the underlying rallies, the option MAKES moneyA Negative Delta will move OPPOSITE of a stockWhen the underlying rallies, the option will LOSE money

3 DefinitionsChange in the option price with a $1 move in the underlyingDelta is a hedge ratiohow many shares of a 100.00 lot of stock that particular option hedgesA Loose percentage chance an option finishes ITMDelta is a options sensitivity to a stocks PRICE DIRECTIONAL movement

Easy Greeks DeltaDelta has a range of -1.00 to +1.00Options with negative deltas negatively correlate to the underlyingOptions with positive deltas will positively correlate with the underlyingThe closer the delta is to 1 or -1 the more it correlates positively or negatively with movement in the underlying

Calls and PutsCalls have a positive deltaBuying a call is going long deltaSelling a call is going short deltaPuts have a negative deltaBuying a put is going short deltaSelling a put is going long deltaBut different positions!But different positions!

Using the Greeks as a Risk Management Tool

Easy Greeks- Gamma

GammaThe simplest definition of gamma is: it is how delta changes as the underlying price changesThe measure is how much delta will change with a 1 point move in the underlyingIt is the options sensitivity to a stocks MOVEMENT regardless of directionCalled REALIZED Volatility

GammaIf a trader buys calls or puts, the trader is long gammaIf the trader sells calls or sells puts, the trader is short gammaThe sign of delta and the sign of gamma have NOTHING to do with each otherA trader can be long delta and short gammaA trader can be short delta and long gamma

GammaLong GammaIf the position is long gamma as the underlying rallies, the position will increase in deltaIf the position is long gamma as the underlying falls, the position will decrease in deltaShort GammaIf the position is short gamma as the underlying rallies, the position will decrease in deltaIf the position is short gamma as the underlying falls, the position will increase in delta

Easy Greeks- Theta

ThetaThe simplest definition of theta is: it is the rate at which an options time premium or fluff is disappearingHow quickly is the insurance value heading to 0The technical definition is the sensitivity of the option to the passage of timeTheta measures TIME RISK

What is Time DecayTime Decay is the difference between a stocks intrinsic value vs. the stocks extrinsic valueEXAMPLE: XYZ is trading 28, the 25 dollar call is trading 5.00 evenIntrinsic Value: 3.00Extrinsic Value 2.00At expirationIntrinsic V