Transcript
Page 1: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

The Option Pit Method

Option Pit

Option Pit Boot Camp

The Option Pit MethodFor trading options

Page 2: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Option Boot Camp- The Option Pit Method

- The Option Pit method uses- Position Structure- Efficient use of Capital- Risk 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

Page 3: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

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

Page 4: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Option Boot Camp- What you will learn

• What makes an option move? Intent!– Inputs and Greeks

• Understanding Volatility Conditions• Trade selection

• We will cover spreads, collars and butterflies

• Use the Greeks to manage your book- Intro to risk management

Page 5: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Boot Camp I- What you will learn

• The Option Pit Input Circle

• The Option Model

• The Greeks – Delta, Gamma, Theta, Vega

Page 6: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

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

Page 7: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

The Option Pit Input Circle

What makes an option move?

Page 8: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Moneyness- Which Strike

• Are the options big dollars or small dollars?• As the strike price goes from lower to higher– Calls will go from ITM to OTM– Puts will go from OTM to ITM

• The more ITM the strike price is, the more it is sensitive to changes in price

• The further out in time we go, the more the strikes act alike• The higher the volatility, the more the strikes act alike• The more ITM the option is, the more cost of carry issues

come into play

Page 9: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Direction of the Underlying- Price

• Price of the underlying is one of the inputs that most traders get– When price goes up, calls gain value• The lower the strike price, the more value it will gain

from price• The further out in time one owns the option, the less

sensitive to price the options will be• The higher volatility of the underlying, the less sensitive

to price the option will be

Page 10: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Direction of the Underlying- Price

•When price goes down, puts gain value• The higher the strike price, the more value it will gain

from price• The further out in time one owns the option, the less

sensitive to price the options will be• The higher volatility of the underlying, the less sensitive

to price the option will be

Page 11: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Time to Expiration- Expiration Date

• Time is money!

– Small price changes will have little effect on the price of the option

– Calls and put at all strikes will all head towards being ATM options

– Options become more sensitive to changes in a stock’s volatility

– More time, more issues with cost of carry (dividends)

Page 12: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Time Decay- Long or Short Options

• Does 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

Page 13: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Volatility

• How much does the underlying move?– That is volatility

• Of all the inputs in the model, this is the only one we really don’t know– Interestingly enough, the model is trying to use

‘forward volatility’– Ends up using implied volatility

• As volatility increases, the value of all options increases– Buying insurance before or after a hurricane

Page 14: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Add the inputs together

• Once all the inputs are accounted for, investors can start to generate an idea for a position

• Some of the inputs are easy and some are much harder

• Look at risk now for the goodies you get versus the risk of the inputs changing

Page 15: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Pricing Model Uses Inputs

Inputs

Theoretical Value

Page 16: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

What is a Normal Distribution• Assumes stocks have an equal chance of

moving up or down at any given time

Page 17: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Variance

• When a distribution moves within a normal range, it is called a variance

• A variance represents how much we would expect the data set to vary most of the time

• We use variances all the time as traders

Page 18: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

What is Volatility

• Volatility is another word for the statistical term variance over a specific range of time– Represents an expected range for a stock or index

on an annualized basis regardless of direction

• A 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

Page 19: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Standard Deviation

• Standard 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 time– Allows for use to analyze earnings, events, low

and high vol, you name it

Page 20: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Standard Deviation Calculation

• SPX midday Dec 9th 2014

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

– So .166 x (37/365)sq rt = .052– 2041 x .052 = $107 for roughly 2/3 of the time

Page 21: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

What is Volatility

• There are 3 kinds of volatility we will talk about:– Historical Volatility

– Forward Volatility

– Implied Volatility

Page 22: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Forward Volatility

• How much is a stock moving from RIGHT NOW until EXPIRATION– Impossible to gauge

• We are trying to be fortune tellers– Can use estimates like volatility charts• Involves overnight risk• Weekend risk• Intraday risk

Page 23: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Historical Volatility

• How much has the stock moved over the last time period– High-Low Volatility– Intraday Range– Close Close– Open Open

• 10 day, 20 day, 30 Day, 90 day, 180 day– I like 20 day because it is has some noise– Tracks 30 day IV

Page 24: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Implied Volatility

• We will dig into this more, but:– Implied Volatility is actually an OUTPUT

• Because it is an OUTPUT, and we do not know what the stock's volatility is, Implied Vol is actually an output

• Garbage in, Garbage out

Page 25: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Implied Volatility

• Issues 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 high– Because an instrument may have many strike

prices, hedges or speculations can still be wrong– The BID-ASK spread in options can throw off IV

Page 26: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Reversion

• In any given year, an event can cause a security to have an “outlier” volatility

• But, over time, volatility of any asset will tend to mean revert– This means that it will hover around its average– This applies to all types of volatility that can be

measured• HV will revert to its mean• IV will revert to its mean• FV will overtime BE the mean

Page 27: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Understanding risk in terms of inputs

• The GREEKS ARE AN OUTPUT of a pricing model not an input

• As the 5 factors change, so do the Greeks• The Big Greeks Are:– Delta– Gamma– Vega– Theta

Page 28: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Easy Greeks

Page 29: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Using the Greeks as a Risk Management Tool

Page 30: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

How to get to P/L

Option Pit FLOW CHART

Page 31: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Easy Greeks- Delta

Page 32: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Easy Greeks- Delta

• The way an option’s price will move with the underlying price, sometimes called correlation

• A Positive Delta will move just like stock– when the underlying rallies, the option MAKES

money• A Negative Delta will move OPPOSITE of a

stock– When the underlying rallies, the option will LOSE

money

Page 33: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

3 Definitions

• Change in the option price with a $1 move in the underlying

• Delta is a hedge ratio– how many shares of a 100.00 lot of stock that

particular option hedges• A Loose percentage chance an option finishes

ITMDelta is a option’s sensitivity to a stock’s PRICE DIRECTIONAL movement

Page 34: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Easy Greeks Delta

• Delta has a range of -1.00 to +1.00– Options with negative deltas negatively correlate

to the underlying– Options with positive deltas will positively

correlate with the underlying– The closer the delta is to 1 or -1 the more it

correlates positively or negatively with movement in the underlying

Page 35: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Calls and Puts

• Calls have a positive delta– Buying a call is going long delta– Selling a call is going short delta

• Puts have a negative delta– Buying a put is going short delta– Selling a put is going long delta

But different positions!

But different positions!

Page 36: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Using the Greeks as a Risk Management Tool

Page 37: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Easy Greeks- Gamma

Page 38: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Gamma

• The simplest definition of gamma is: it is how delta changes as the underlying price changes– The measure is how much delta will change with a

1 point move in the underlying

• It is the options sensitivity to a stock’s MOVEMENT regardless of direction– Called REALIZED Volatility

Page 39: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Gamma

• If a trader buys calls or puts, the trader is long gamma

• If the trader sells calls or sells puts, the trader is short gamma– The sign of delta and the sign of gamma have

NOTHING to do with each other– A trader can be long delta and short gamma– A trader can be short delta and long gamma

Page 40: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Gamma

• Long Gamma– If the position is long gamma as the underlying

rallies, the position will increase in delta– If the position is long gamma as the underlying

falls, the position will decrease in delta• Short Gamma– If the position is short gamma as the underlying

rallies, the position will decrease in delta– If the position is short gamma as the underlying

falls, the position will increase in delta

Page 41: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Easy Greeks- Theta

Page 42: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Theta

• The simplest definition of theta is: it is the rate at which an option’s time premium or ‘fluff’ is disappearing– How quickly is the ‘insurance value’ heading to 0

• The technical definition is the sensitivity of the option to the passage of time

• Theta measures TIME RISK

Page 43: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

What is Time Decay

• Time Decay is the difference between a stocks intrinsic value vs. the stocks extrinsic value

• EXAMPLE: XYZ is trading 28, the 25 dollar call is trading 5.00 even– Intrinsic Value: 3.00– Extrinsic Value 2.00

• At expiration– Intrinsic Value: 3.00– Extrinsic Value: 0

Page 44: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Theta

• A positive theta position will benefit with the passage of time (as time passes position MAKES $$$)

• A negative theta position will be hurt by the passage of time (as time passes position will lose $$$)

• Long options have negative theta• Short options have positive theta

Page 45: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Using the Greeks as a Risk Management Tool

Page 46: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Easy Greeks - Vega

Calm seas or rough seas?

Page 47: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Vega

• The Vega S.A.T. question:– Delta is to Change in Price as Vega is to:

• White Castle Sliders• Implied Volatility• Chevy Camaro IROC-Z• Cat Nip

• Vega is the change in Profit from a 1 point move in implied volatility

• Vega measures CHANGE in IMPLIED VOLATILTY RISK

Page 48: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Vega

• A positive (+) Vega position will benefit with an increase in implied volatility

• A negative (-) Vega position will be hurt by an increase in implied volatility

• Long options have positive Vega (long juice)• Short options have negative Vega (short juice)

Page 49: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Vega

• If a trader buys calls or puts, the trader is long Vega

• If the trader sells calls or sells puts, the trader is short Vega

• There is a trade off protection against IV movement vs. collecting premium– The insurer vs. the insuree

• Think time line as we go into the 5 factors- 60 days, 30 days, 10 days?

Page 50: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Using the Greeks as a Risk Management Tool

Page 51: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Managing Risk with Greeks

• Managing Risk is about what the trader Does not know.

– First understand how the Greeks balance against each other in one position

– How do your positions work together?

• Let’s walk through some examples

Page 52: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Using the Greeks as a Risk Management Tool

• Delta- Managing the direction of the position• Gamma- Managing the change in delta• Vega- Managing the change in volatility• Theta- Managing the change in time

(dividend)

Page 53: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Summary

• Inputs move option prices

• Changing inputs move Greeks

• Greeks measure risk and profit and loss potential

• Use the Greeks to take the risk you want

Page 54: The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Option Pit Boot Camp 1 Quiz

•What is the flow of model inputs to generate P/L? •Is acceleration a fair way to describe gamma and what is the market factor most closely associated with it? •What is positive Theta? Is it free? •What is Vega in a position? Please explain.


Recommended