Option strategies when volatilities are low. Alan Grigoletto, CEO Grigoletto Financial Consulting

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1 Option strategies when volatilities are low Alan Grigoletto, CEO Grigoletto Financial Consulting

2 Limitation of liability The opinions expressed in this presentation are those of the author(s) and presenter(s) only and do not necessarily represent the views of of the Bourse de Montréal Inc. (the Bourse ) and/or its affiliates. This document is offered for general information purposes only. The information provided in this document, including financial and economic data, quotes and any analysis or interpretation thereof, is provided solely for information purposes and shall not be construed in any jurisdiction as providing any advice or recommendation with respect to the purchase or sale of any derivative instrument, underlying security or any other financial instrument or as providing legal, accounting, tax, financial or investment advice. The Bourse recommends that you consult your own advisors in accordance with your needs. All references in this document to specifications, rules and obligations concerning a product are subject to the rules, policies and procedures of the Bourse and its clearinghouse, the Canadian Derivatives Clearing Corporation, which prevail over this document. Although care has been taken in the preparation of this document, the Bourse and/or its affiliates do not guarantee the accuracy or completeness of the information contained in this document and reserve the right to amend or review the content of this document any time and without prior notice. Neither the Bourse, nor any of its affiliates, directors, officers, employees or agents shall be liable for any damages, losses or costs incurred as a result of any errors or omissions in this document or of the use of or reliance upon any information appearing in this document.

3 02 Outline Historical Volatility Standard Deviation Calculating Volatility Options Volatility Long Straddle and Strangle Debit Spreads Calendar Spreads

4 03 Historical Volatility A stock s volatility in the past: Can be observed and quantified This is historical volatility A statistic, or a fact, not a prediction Today Stock Price Time

5 04 Higher vs. Lower Volatility Compare price action of two stocks over a given time period: Both begin and end timeframe at same price What happens during timeframe is volatility Stock Price More volatile Less volatile Time

6 05 Normal Distribution Consider stock XYZ and its distribution of closing prices over a short timeframe Normal distribution when number of occurrences and price range on upside mirror image of downside Mean Occurrence *Not drawn to scale Closing Prices

7 06 Historical Volatility and Standard Deviation With a 25% historical volatility XYZ has been within ± 1 SD of $25.00 from mean 68% of the time within ± 2 SDs of $50.00 from mean 95% of the time within ± 3 SDs of $75.00 from mean 99% of the time *Not drawn to scale $100 Mean

8 07 Historical Volatility Sources How to find historical volatility Brokerage firm web sites Quote service Option advisory service On the web Historical volatility can be recalculated daily, weekly, etc. DIY Spreadsheet facilitates the calculations Formulas available on the web

9 08 Standard Deviation Example XYZ is currently at $60 Volatility assumption 20% XYZ to trade between $48 and $72 (±20%) 1 year time frame 68% of time or 1 standard deviation 32% of time outside of this range

10 09 Look into the Future: 1 Day XYZ is trading at $60.00 options at annualized 20% implied volatility Standard deviation amount for 1-trading day: 20% 252 x $60.00 = x $60.00 =.012 x $60.00 $.76 Statistically, you can expect the following results for XYZ over the next 1 trading day: Variance Standard Deviation Amount Trading Range Probability Within Range Probability Outside Range ± 1 SD $.76 $59.24 $ % 32% ± 2 SD $1.52 $58.48 $ % 5% ± 3 SD $2.28 $57.72 $ % 1%

11 10 Implied Volatility: Definition Option implied volatility is: Volatility assumption at which option is currently priced in market Can be determined via option pricing as model Volatility input value is now = current option market price Reflects underlying volatility expected by marketplace and is the consensus of all market participants Who ultimately determines option market prices? Everybody who makes a bid/ask price and trades an option Professionals and individual investors alike

12 11 Market Prices of Options When valuing an option with a pricing model (option calculator) You might start with a stock s historical volatility to predict future volatility. You could also use an expected volatility for the stock When the current market price for an option seems too high or too low to you, you can raise or lower the implied volatility input. If all other inputs are correct then it is implied volatility determining the current price.

13 12 What is skew? The volatility skew is the difference in implied volatility (IV) between out-of-the-money options, at-the-money options and in-the-money options. Volatility skew is affected by supply and demand, and reflects whether participants in the market prefer to write covered calls or sell puts. It is directional bias. Normally, the world sells calls for income and buys puts for protection.

14 13 Smile like you mean it What happened during the crash of 1987 changed forever the skewness of options. Markets accelerate to the downside with much more velocity than they do to the upside. Out-of-the-money puts were more valuable than out-of-the-money calls. Managed covered call strategies, pushed call option prices down, while the needs for portfolio protection pushed put prices upward. Graph the differences in the implied volatilities, we would get a smile or smirk. The volatility smile reflects higher implied volatility as options move more in-the-money or more out-of-the money. Two types of skews: Time skew and Strike skew Time skew is a measure of the difference in implied volatility of options with the same price but different expirations. Strike skew measures the difference in option volatility for option contracts with different strikes but the same expiration.

15 14 Volatility Smile Example XIU strike skew Courtesy of Bloomberg

16 15 Strategies for Vega Increase Objective Profit from increase in implied volatility Low market risk Method Establish delta neutral strategy Get long vega Long straddle Buy at-the-money call Buy at-the-money put Same strike and expiration

17 16 Straddles and Strangles Long straddles and strangles: Buying two options doubly exposed to volatility Can profit from implied increase without stock move If implied doesn t increase, need relatively large increase in stock volatility to profit The above strategies carry limited risk

18 17 Long Straddle Long straddle: Buy one call and buy one put Both options have: Same underlying stock Same strike price Same expiration month Long Straddle Motivation: Take advantage of increasing volatility Expect a significant move in underlying stock

19 18 Long Straddle Example Stock XYZ currently at $50.00 Buy: 1 XYZ Jan $50.00 call $ XYZ Jan $50.00 put $3.00 Net cost: $6.20 debit XYZ $50.00 straddle purchased for $6.20, or $ total, plus commissions

20 19 Long Straddle Example Buy 1 XYZ Jan $50.00 call at $3.20 Buy 1 XYZ Jan $50.00 put at $3.00 $6.20 debit Stock Price at maturity $50.00 Call Profit/(Loss) $50.00 Put Profit/(Loss) Combined Profit/(Loss) $60.00 $6.80 ($3.00) $3.80 $56.20 $3.00 ($3.00) 0 $55.00 $1.80 ($3.00) ($1.20) $50.00 ($3.20) ($3.00) ($6.20) $45.00 ($3.20) $2.00 ($1.20) $43.80 ($3.20) $ $40.00 ($3.20) $7.00 $3.80 Not including commissions

21 20 Long Straddle Example Maximum Loss: $6.20 Debit Paid $ Total BEP $43.80 BEP $ Break-even at Expiration: Upside = Strike + Debit Paid $ $6.20 = $56.20 Downside = Strike Debit Paid $50.00 $6.20 = $43.80 Not including commissions

22 21 Long Strangle Long strangle: Buy one call higher strike price Buy one put lower strike price Both options have: Same underlying stock Same expiration month Motivation: Take advantage of increasing volatility Lower cost than straddle Long Strangle

23 22 Long Strangle Example Stock XYZ currently at $50.00 Buy: 1 XYZ Jan $55.00 call $ XYZ Jan $45.00 put $1.05 Net cost: $2.45 debit XYZ $45.00-$55.00 strangle purchased for $2.45, or $ total, plus commissions

24 23 Long Strangle Example Buy 1 XYZ Jan $55.00 call at $1.40 Buy 1 XYZ Jan $45.00 put at $1.05 $2.45 debit Stock Price at maturity $55.00 Call Profit/(Loss) $45.00 Put Profit/(Loss) Combined Profit/(Loss) $60.00 $3.60 ($1.05) $2.55 $57.45 $1.05 ($1.05) 0 $55.00 ($1.40) ($1.05) ($2.45) $50.00 ($1.40) ($1.05) ($2.45) $45.00 ($1.40) ($1.05) ($2.45) $42.55 ($1.40) $ $40.00 ($1.40) $3.95 $2.55 Not including commissions

25 24 Long Strangle Example Maximum Loss: $2.45 Debit Paid $ Total BEP $ BEP $57.45 Break-even at Expiration: Upside = Call Strike + Debit Paid $ $2.45 = $57.45 Downside = Put Strike Debit Paid $45.00 $2.45 = $42.55 Not including commissions

26 25 Straddles versus Strangles Straddles: Higher cost and lower leverage Break-even points closer together Less chance of 100% loss Strangles: Lower cost and higher leverage Break-even points farther apart Greater chance of 100% loss Both: time decay is painful and need big stock move

27 26 Debit Spread Characteristics Bull Call Spreads and Bear Put Spreads Maximum loss Limited to net debit paid for spread Maximum profit potential Difference between strike prices net debit paid Margin Net debit must be paid in full

28 27 Bear Put Spread Bear put spread Buy one put and sell another put with low strike Same expiration month Same underlying stock Always a debit spread Higher-strike put always costs more than lower-strike put

29 28 Bear Put Spread Example Stock CNQ currently at $39. Forecast: Stock down 10% by expiry Spread: Buy 1 CNQ $40.00 put $2.50 Sell 1 CNQ $35.00 put + $1.00 Net cost: $1.50 debit CNQ put spread purchased for $1.50, or $ total, plus commissions

30 29 Bear Put Spread Example Buy 1 CNQ $40 put $2.50 / Sell 1 CNQ $35 put +$1.00 Buy 1 XYZ 40 put at $2.50 Stock price $40 Put $35 Put $1.50 Combined debit Sell 1 XYZ 35 Profit/(Loss) put at $1.00 Profit/(Loss) at expiry Profit/(Loss) $45.00 $40.00 ($2.50) ($2.50) $1.00 $1.00 $38.50 ($1.00) $1.00 $35.00 $2.50 $1.00 $30.00 $7.50 ($4.00) ($1.50) ($1.50) 0 $3.50 $3.50

31 30 Bear Put Spread Example BEP $ Maximum Profit: Strike Difference Debit Paid $5.00 $1.50 = $3.50 $ Total Maximum Loss: $1.50 Debit Paid $ Total Break-even at Expiration: Higher Put Strike Debit Paid $40.00 $1.50 = $38.50

32 31 Possible Outcome 1 at Expiration Buy 1 CNQ $40 put $2.50 Sell 1 CNQ $35 put +$1.00 Net cost: $1.50 debit CNQ stock above $40.00? $40 put expires worthless $35 put expires worthless Result Maximum loss ($1.50 debit)

33 32 Possible Outcome 2 at Expiration Buy 1 CNQ $40 put $2.50 Sell 1 CNQ $35 put +$1.00 Net cost: $1.50 debit CNQ stock between $35.00 and $40.00? $40 put in-the-money sell intrinsic $35 put expires worthless result partial loss or partial profit or if $40 put exercised sell stock Effective price = $38.50

34 33 Comparing Implied Volatilities Example Not related to earlier example

35 34 Calendar (Time) Spread Time spread (all calls or all puts) Buy one far-term option Sell one near-term option Same strike price Same underlying stock Simultaneous transactions Always a debit spread Far-term option will always cost more than near-term with same strike Bullish, bearish or neutral

36 35 Calendar (Time) Spread Expectation Neutral on the underlying stock Underlying stock stable at strike price Profit from time decay of short call Long call retains time value Maximum profit Stock closes at strike on near-term expiration Near-term option expires worthless Long option retains as much time value as possible

37 36 Calendar Spread Calculating maximum profit accurately in advance is not possible If stock at strike on near-term expiration what will the long far-term option be worth? Pricing model is best tool for estimating As near-term expiration approaches If short option is in-the-money there is assignment risk If assignment is not acceptable consider closing entire spread position

38 37 Long Time Spread Position Greeks short theta (net positive) Take advantage of difference in decay rates Greater theta of short near-term contract Smaller theta of long far-term contract Time Value $$$ Long Call Short Call Time

39 38 Long Time Spread Position Greeks long vega (net positive) Implied increase benefits long far-term option Boosts profit at near-term expiration As near-term expiration approaches Short option in-the-money Assignment risk After early assignment long option maintained Call spread Short stock Synthetic put Put spread Long stock Synthetic call Assignment unacceptable Consider closing spread

40 39 Bullish or Bearish Time Spreads If slightly bullish Use strike price above current stock price Stock price increase needed for strike to be at-the-money at near-term expiration For call or put time spreads If slightly bearish Use strike price below current stock price Stock price decrease needed for strike to be at-the-money at near-term expiration For call or put time spreads

41 40 Long Put Calendar At the expiration of the near-term option, the maximum gain would occur should the underlying stock be at the strike price of the expiring option. If the stock were any lower, the expiring option would have intrinsic value, and if the stock were any higher the longer-term option would have less value. Once the near-term option has expired worthless, the investor is left with simply a long put, whose potential profit is limited only because the stock cannot go below zero. The potential profit is limited to the extent the near-term option declines in value more quickly than the longer-term option (time decay). Once the near-term option has expired, however, the strategy becomes simply a long put whose potential profit is substantial. The potential loss is limited to the premium paid to initiate the position.

42 41 Put Time Spread Example Stock XYZ at $ options 16% implied Time spread: Buy 1 XYZ 80-day $ Put $4.30 Sell 1 XYZ 31-day $ Put +$2.65 Net paid: $1.65 debit Position Greeks Γ Θ Κ Long 80-day Put Short 31-day Put Net for position Not including commissions

43 42 At Near-Term Expiration Put Time Spread Profit/Loss Stock Price Not including commissions

44 43 Calendar Breakdown The break-even of the strategy is a function of the underlying stock price, implied volatility and rates of time decay. Should the near-term option expire worthless, breakeven at the longer-term option's expiration would occur if the stock were below the strike price by the amount of the premium paid. But of course it could occur at any time should the position be closed out for a credit equal to the debit paid when the position was initiated. An increase in implied volatility, all other things equal, would have an extremely positive impact on this strategy. In general, longer-term options have a greater sensitivity to changes in market volatility, i.e., a higher Vega. Be aware, however, that the near and far-term options could and probably will trade at different implied volatility levels. The passage of time, all other things equal, would have a positive impact on this strategy in the beginning. That changes, however, once the near-term option has expired and the strategy becomes simply a long put whose value will be eroded by the passage of time. In general, an option's rate of time decay increases as its expiration draws nearer.

45 44 Calendar Exit Early assignment, while possible at any time, generally occurs for a put only when it goes deep-in-the-money. Should early exercise occur, using the longer-term option to cover the assignment would require financing a long stock position for one business day. And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock Should the near-term put (the short side of the spread) be exercised when it expires, the longer-term put option would remain to provide a hedge. However, assignment on the near-term put would result in the investor entering into a long stock position. If the longer-term put were held into expiration, it could be subject to autoexercise if in-the-money.

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