Option Fundamentals Rajib Ranjan Borah & Nitesh Khandelwal QuantInsti Bangkok, 6 Oct 2014

Transcription

1 Option Trading Techniques: A Trader s Approach for a Retail Investor Option Fundamentals Rajib Ranjan Borah & Nitesh Khandelwal QuantInsti Bangkok, 6 Oct 2014

2 2 Topics Fundamentals Strategies Managing positions Sophistication through automation

3 3 Topics Fundamentals Understanding basics of options and derivatives Strategies Managing positions Sophistication through automation

4 4 Topics Fundamentals Strategies A Few Simple Option Trading Strategies Managing positions Sophistication through automation

5 5 Topics Fundamentals Strategies Managing positions Initiating and Managing Option Positions Handling risks different risk management parameters Sophistication through automation

6 6 Topics Fundamentals Strategies Managing positions Sophistication through automation Advanced Trading Strategies Complex Position Management using Automation

7 Fundamentals Strategies Position Management Definitions Automation & Sophistication 7 Derivative is a financial instrument whose price is derived from the price of some other financial instrument. Option is a special type of derivative instrument - the buyer of the option has the option (i.e. right but not the obligation) to buy/sell a specified amount of underlying asset at a specified price on or before a specified date Other types of common derivatives: Future: the owner of such a derivative is obligated to buy/sell a specified amount of underlying asset at a specified price on a specified date Forward: Similar to futures, but traded OTC instead of in the exchange

8 Fundamentals Strategies Position Management Automation & Sophistication 8 Option Types Two types of options Call Options: Buyer has the option (but not the obligation) to buy the underlying Put Options: Buyer has the option (but not the obligation) to sell the underlying Defining Characteristics of Option Instruments Strike: Price of the underlying at which the option can be exercised Expiry Date: The date at which the option can be exercised Premium: Upfront payment made by the buyer of the option (to the seller) Option Styles European: can be exercised only on expiry date American: can be exercised anytime prior to expiry date Exotic Bermudan, Asian, Binary, Barrier, etc

9 Fundamentals Strategies Position Management Option Types Elaborated Automation & Sophistication 9 B U Y E R S E L L E R CALL OPTION The right (but not the obligation) to buy The potential obligation to sell PUT OPTION The right (but not the obligation) to sell The potential obligation to buy

10 Fundamentals Strategies Position Management Automation & Sophistication Payoff from holding a call option instrument 10 Consider a Call Option on XYZ stock with strike = 30, expiry date = 30th August 201X At Expiry the payoff of the call option for the buyer is as shown below: Strike at 30 Will only exercise the call option if underlying at expiry is more than the strike Underlying price at expiry For e.g., if the underlying price is at 36, the buyer of the option can buy the underlying at 30. Hence, a payoff of 6.

11 Fundamentals Strategies Position Management Automation & Sophistication 11 Payoff from holding a put option instrument Consider a Put Option on XYZ stock with strike = 30, expiry date = 30 th August 201X. At Expiry the payoff of the put option for the buyer is as shown below: Will only exercise the call option if underlying at expiry is less than the strike Strike at For e.g., if the underlying price is at 23, the buyer of the option can sell the underlying at 30. Hence, a payoff of

12 Fundamentals Strategies Position Management Automation & Sophistication Payoff - Buy Call Option Breakeven Point Premium Underlying price at expiry Payoff - Sell Call Option Premium Strike Underlying price at expiry Payoff - Buy Put Option Payoff - Sell Put Option Underlying Price at Expiry

13 Fundamentals Strategies Position Management Moneyness Automation & Sophistication 13 Terminology Call Option Put Option In the Money (ITM) Underlying Price > Strike Underlying Price < Strike At the Money (ATM) Underlying Price = Strike Underlying Price = Strike Out the Money (OTM) Underlying Price < Strike Underlying Price > Strike

14 Fundamentals Strategies Position Management Automation & Sophistication 14 Option Premium (price) components: Option price = Intrinsic Value + Time Value Intrinsic Value: Immediate value of the option given the current relationship between the price of underlying and the price of the option For call options, intrinsic value = underlying option strike For put options, intrinsic value = option strike - underlying Time Value: Because the buyer of the option has the upside benefits but not downside obligations, therefore future price movements in the underlying can benefit (but not harm) the buyer therefore there is an additional value for the option instruments for the extra benefits future price movements might bring An option with no intrinsic value is an Out of The Money Option

15 Fundamentals Strategies Position Management Option Pricing Methodology Automation & Sophistication 15 Pricing depends on key characteristics of instrument Option Strike Option Expiry date Current Underlying Price Characteristics of price change in underlying (volatility, price jumps, etc) Interest Rate & Stock Borrowing Rates Dividends Option type (Call/Put) Option Style (American/European)

16 Fundamentals Strategies Position Management Option Pricing Methodology Automation & Sophistication 16 Common Pricing Formulations Underlying Characteristic Constant Volatility Constant Volatility with Dividends Constant Volatility with Poisson Jumps Volatility as a function of Underlying price Volatility as a function of Underlying price & time to expiry Volatility is volatile American type expiry Currency Options Pricing Methodology Black Scholes Black Scholes Merton Merton Jump Diffusion CEV Derman Kani Heston Barone Adesi Whaley, Bjerksund Stensland Garman Kohlhagen

17 Fundamentals Strategies Position Management Question & Answers Automation & Sophistication 17 Thank You Danke Arigato Grazi Shukriya Merci Gracias Asante / / Go Algo! Join QI s EPAT (Executive Program on Algorithmic Trading)!

18 Options Trading Techniques: A Trader s Approach for a Retail Investor Global Trends in Option Trading Rajib Ranjan Borah & Nitesh Khandelwal QuantInsti Bangkok, 6 th October 2014

19 Relevant factors for analyzing different markets Current landscape in different geographies QA How do you decide: where to trade? As a trading manager, how do you decide which geographies to trade?

20 Relevant factors for analyzing different markets Current landscape in different geographies QA How do you decide: where to trade? As a trading manager, how do you decide which geographies to trade?

21 Relevant factors for analyzing different markets Current landscape in different geographies QA How do you decide: where to trade? As a trading manager, how do you decide which geographies to trade? Am I allowed to trade in that country (i.e. how conducive are regulations)?

22 Relevant factors for analyzing different markets Current landscape in different geographies QA How do you decide: where to trade? As a trading manager, how do you decide which geographies to trade? Am I allowed to trade in that country (i.e. how conducive are regulations)? Are foreigners allowed to trade? Are there restrictions on position-sizing / short-selling?

23 Relevant factors for analyzing different markets Current landscape in different geographies QA How do you decide: where to trade? As a trading manager, how do you decide which geographies to trade? Am I allowed to trade in that country (i.e. how conducive are regulations)? Are foreigners allowed to trade? Are there restrictions on position-sizing / short-selling?

24 Relevant factors for analyzing different markets Current landscape in different geographies QA How do you decide: where to trade? As a trading manager, how do you decide which geographies to trade? Am I allowed to trade in that country (i.e. how conducive are regulations)? Are foreigners allowed to trade? Are there restrictions on position-sizing / short-selling? Are these markets interesting to trade?

25 Relevant factors for analyzing different markets Current landscape in different geographies QA How do you decide: where to trade? As a trading manager, how do you decide which geographies to trade? Am I allowed to trade in that country (i.e. how conducive are regulations)? Are foreigners allowed to trade? Are there restrictions on position-sizing / short-selling? Are these markets interesting to trade? What are the listed instruments? What is the volume traded?

26 Relevant factors for analyzing different markets Current landscape in different geographies QA How do you decide: where to trade? As a trading manager, how do you decide which geographies to trade? Am I allowed to trade in that country (i.e. how conducive are regulations)? Are foreigners allowed to trade? Are there restrictions on position-sizing / short-selling? Are these markets interesting to trade? What are the listed instruments? What is the volume traded? Will I be able to make profits?

27 Relevant factors for analyzing different markets Current landscape in different geographies QA How do you decide: where to trade? As a trading manager, how do you decide which geographies to trade? Am I allowed to trade in that country (i.e. how conducive are regulations)? Are foreigners allowed to trade? Are there restrictions on position-sizing / short-selling? Are these markets interesting to trade? What are the listed instruments? What is the volume traded? Will I be able to make profits? What is the level of sophistication of competition? Who are the leading players?

28 Relevant factors for analyzing different markets Current landscape in different geographies QA How do you decide: where to trade? As a trading manager, how do you decide which geographies to trade? Am I allowed to trade in that country (i.e. how conducive are regulations)? Are foreigners allowed to trade? Are there restrictions on position-sizing / short-selling? Are these markets interesting to trade? What are the listed instruments? What is the volume traded? Will I be able to make profits? What is the level of sophistication of competition? Who are the leading players? What are the complexities to connecting to these markets? Technological protocols used by these exchanges common standard protocols OR unique custom protocols Brokers to connect to these markets

29 Relevant factors for analyzing different markets Current landscape in different geographies QA How do you decide: where to trade? As a trading manager, how do you decide which geographies to trade? Am I allowed to trade in that country (i.e. how conducive are regulations)? Are foreigners allowed to trade? Are there restrictions on position-sizing / short-selling? Are these markets interesting to trade? What are the listed instruments? What is the volume traded? Will I be able to make profits? What is the level of sophistication of competition? Who are the leading players? What are the complexities to connecting to these markets? Technological protocols used by these exchanges common standard protocols OR unique custom protocols Brokers to connect to these markets

30 Relevant factors for analyzing different markets Current landscape in different geographies QA How do you decide: where to trade? As a trading manager, how do you decide which geographies to trade? Am I allowed to trade in that country (i.e. how conducive are regulations)? Are foreigners allowed to trade? Are there restrictions on position-sizing / short-selling? Are these markets interesting to trade? What are the listed instruments? What is the volume traded? Will I be able to make profits? What is the level of sophistication of competition? Who are the leading players? What are the complexities to connecting to these markets? Technological protocols used by these exchanges common standard protocols OR unique custom protocols Brokers to connect to these markets Regulations

31 Relevant factors for analyzing different markets Current landscape in different geographies QA How do you decide: where to trade? As a trading manager, how do you decide which geographies to trade? Am I allowed to trade in that country (i.e. how conducive are regulations)? Are foreigners allowed to trade? Are there restrictions on position-sizing / short-selling? Are these markets interesting to trade? What are the listed instruments? What is the volume traded? Will I be able to make profits? What is the level of sophistication of competition? Who are the leading players? What are the complexities to connecting to these markets? Technological protocols used by these exchanges common standard protocols OR unique custom protocols Brokers to connect to these markets Regulations Market Size

32 Relevant factors for analyzing different markets Current landscape in different geographies QA How do you decide: where to trade? As a trading manager, how do you decide which geographies to trade? Am I allowed to trade in that country (i.e. how conducive are regulations)? Are foreigners allowed to trade? Are there restrictions on position-sizing / short-selling? Are these markets interesting to trade? What are the listed instruments? What is the volume traded? Will I be able to make profits? What is the level of sophistication of competition? Who are the leading players? What are the complexities to connecting to these markets? Technological protocols used by these exchanges common standard protocols OR unique custom protocols Brokers to connect to these markets Regulations Market Size Competition

33 Relevant factors for analyzing different markets Current landscape in different geographies QA How do you decide: where to trade? As a trading manager, how do you decide which geographies to trade? Am I allowed to trade in that country (i.e. how conducive are regulations)? Are foreigners allowed to trade? Are there restrictions on position-sizing / short-selling? Are these markets interesting to trade? What are the listed instruments? What is the volume traded? Will I be able to make profits? What is the level of sophistication of competition? Who are the leading players? What are the complexities to connecting to these markets Technology? Technological protocols used by these exchanges common standard protocols OR unique custom protocols Brokers to connect to these markets Regulations Market Size Competition

34 Relevant factors for analyzing different markets Current landscape in different geographies QA How do you decide: where to trade? As a trading manager, how do you decide which geographies to trade? Am I allowed to trade in that country (i.e. how conducive are regulations)? Are foreigners allowed to trade? Are there restrictions on position-sizing / short-selling? Are these markets interesting to trade? What are the listed instruments? What is the volume traded? Will I be able to make profits? What is the level of sophistication of competition? Who are the leading players? What are the complexities to connecting to these markets Technology? Technological protocols used by these exchanges common standard protocols OR unique custom protocols Brokers to connect to these markets Regulations Market Size Competition

35 Relevant factors for analyzing different markets Current landscape in different geographies QA Trading in various landscapes

36 Relevant factors for analyzing different markets Current landscape in different geographies QA Equity volumes avg monthly volumes (USD million) Americas APAC Europe MEA: Middle East + Africa Bermuda SE 4 BM&FBOVESPA 67,550 Buenos Aires SE 279 Colombia SE 2,162 Lima SE 338 Mexican Exchange 14,780 NASDAQ OMX 798,729 NYSE Euronext (US) 1,141,704 Santiago SE 3,640 TMX Group 114,290 Total region 2,143,474 Australian SE 73,463 BSE India 7,046 Bursa Malaysia 12,323 Colombo SE 130 GreTai Securities Market 11,241 HoChiMinh SE 869 Hong Kong Exchanges 110,281 Indonesia SE 9,664 Japan Exchange Group - Osaka 17,594 Japan Exchange Group - Tokyo 525,411 Korea Exchange 107,050 National Stock Exchange India 39,913 New Zealand Exchange 752 Athens Exchange 1,981 BME Spanish Exchanges 74,464 Budapest SE 869 Casablanca SE 263 Cyprus SE 3 Deutsche Börse 111,212 Irish SE 1,206 Ljubljana SE 33 Luxembourg SE 12 Malta SE 6 Moscow Exchange 20,167 NASDAQ OMX Nordic Exchange 52,153 NYSE Euronext (Europe) 138,490 Oslo Børs 10,200 Abu Dhabi SE 1,816 Amman SE 285 Borsa Istanbul 34,947 Cyprus SE 3 Egyptian Exchange 1,077 Irish SE 1,206 Johannesburg SE 28,608 Kazakhstan SE 58 Mauritius SE 26 Muscat Securities Market 478 Qatar Exchange 1,714 Saudi Stock Exchange - Tadawul 30,202 Tel Aviv SE 4,475 Total region 104,895 Philippine SE 3,889 SIX Swiss Exchange 56,413 Shanghai SE 310,927 Wiener Börse 2,154 Shenzhen SE 321,542 Total region 469,626 Singapore Exchange 23,410 Taiwan SE Corp. 51,996 The Stock Exchange of Thailand 31,335 Total region 1,658,838

37 Relevant factors for analyzing different markets Current landscape in different geographies QA Index FO annual volumes (USD million) Americas Options Future BM&FBOVESPA Bourse de Montreal CBOE Future Exchange x NA Chicago Board Options Exchange NA x CME Group Colombia SE x 19.2 ICE Futures US International Securities Exchange NA NA MexDer NASDAQ OMX (US) NA NA NYSE Euronext (US) NA NA APAC Options Future ASX Derivatives Trading ASX SFE Derivatives Trading Bombay SE Bursa Malaysia Derivatives NA China Financial Futures Exchange NA Hong Kong Exchanges Korea Exchange National Stock Exchange India Osaka SE NA Shanghai Futures Exchange Singapore Exchange NA NA TAIFEX Thailand Futures Exchange NA NA Tokyo SE Group NA EMEA Options Future Athens Derivatives Exchange BME Spanish Exchanges Borsa Istanbul Budapest SE EUREX ICE Futures Europe Johannesburg SE Moscow Exchange NYSE.Liffe Europe OMX Nordic Exchange Oslo Børs Tel Aviv SE Wiener Börse

38 Relevant factors for analyzing different markets Current landscape in different geographies QA Equity FO annual volumes (USD million) Americas Options Future BM&FBOVESPA NA Bourse de Montreal Buenos Aires SE NA NA Chicago Board Options Exchange NA NA Colombia SE NA International Securities Exchange NA NA MexDer NASDAQ OMX (US) NA NA NYSE Euronext (US) NA BM&FBOVESPA NA Bourse de Montreal APAC Options Future ASX Derivatives Trading Bombay SE Hong Kong Exchanges Korea Exchange National Stock Exchange India New Zealand 0.0 NA Osaka SE NA NA Shanghai Futures Exchange TAIFEX Thailand Futures Exchange NA NA Tokyo SE Group NA NA EMEA Options Future Athens Derivatives Exchange BME Spanish Exchanges Borsa Istanbul Budapest SE EUREX ICE Futures Europe Johannesburg SE Moscow Exchange NYSE.Liffe Europe OMX Nordic Exchange Oslo Børs Tel Aviv SE NA Wiener Börse

39 Relevant factors for analyzing different markets Current landscape in different geographies QA Currency annual volumes (USD million) Americas Options Future BM&FBOVESPA Bourse de Montreal CME Group Colombia SE NA ICE Futures US MexDer APAC Options Future Hong Kong Exchanges NA Korea Exchange NA National Stock Exchange India Osaka SE NA Thailand Futures Exchange NA NA EMEA Options Future Borsa Istanbul NA Johannesburg SE Moscow Exchange NYSE.Liffe Europe Tel Aviv SE

40 Relevant factors for analyzing different markets Current landscape in different geographies QA Interest Rate annual volumes (USD million) Americas Options Future BM&FBOVESPA Bourse de Montreal Buenos Aires SE NA NA CME Group Colombia SE NA MexDer NA NYSE Euronext (US) NA NA APAC Options Future ASX SFE Derivatives Trading Bombay SE NA NA China Financial Futures Exchange NA Hong Kong Exchanges NA 7.2 Korea Exchange NA National Stock Exchange India NA NA Shanghai Futures Exchange TAIFEX NA 2.2 Tokyo SE Group NA NA EMEA Options Future BME Spanish Exchanges EUREX Johannesburg SE London Metal Exchange NA NA Moscow Exchange NYSE.Liffe Europe OMX Nordic Exchange Tel Aviv SE NA NA

41 Relevant factors for analyzing different markets Current landscape in different geographies QA ETF annual volumes (USD million) Americas ETF ETF Opt BM&FBOVESPA Colombia SE Lima SE 9.8 Mexican Exchange NASDAQ OMX NA NYSE Euronext (US) Santiago SE TMX Group Bourse de Montreal NA CME NA NA ISE NA NA APAC ETF ETF Opt Australian SE BSE India Bursa Malaysia 43.6 Hong Kong Exchanges Indonesia SE 2.1 Japan Exchange Group - Osaka NA Japan Exchange Group - Tokyo NA Korea Exchange National Stock Exchange India New Zealand Exchange 59.6 Shanghai SE Shenzhen SE Singapore Exchange Taiwan SE Corp The Stock Exchange of Thailand EMEA ETF ETF Opt Athens Exchange 14.7 BME Spanish Exchanges Borsa Istanbul Budapest SE 1.9 Deutsche Börse Irish SE 19.3 Johannesburg SE ~ 0 Ljubljana SE 0.0 Luxembourg SE 0.0 NASDAQ OMX Nordic Exchange NYSE Euronext (Europe) Oslo Børs Saudi Stock Exchange - Tadawul 18.6 SIX Swiss Exchange Wiener Börse 5.3

42 Relevant factors for analyzing different markets Current landscape in different geographies QA Commodity annual volumes (USD million) Americas Options Future BM&FBOVESPA CME Group Colombia SE NA 6.6 ICE Futures Canada ICE Futures US NYSE Euronext (US) NA NA APAC Options Future ASX SFE Derivatives Trading Bursa Malaysia Derivatives NA Dalian Commodity Exchange NA Korea Exchange NA New Zealand Shanghai Futures Exchange NA TAIFEX Zhengzhou Commodity Exchange NA EMEA Options Future Borsa Istanbul NA Budapest SE ICE Futures Europe Johannesburg SE London Metal Exchange Moscow Exchange NYSE.Liffe Europe

43 Relevant factors for analyzing different markets Current landscape in different geographies QA Q & A

44 Disclaimer Copyright 2014 by QuantInsti Quantitative Learning Private Limited. Although great care has been taken to ensure accuracy of the information in this presentation however the author (and QuantInsti) accepts no liability or warranty for the precision, correctness or completeness of any statement, estimate or opinion. QuantInsti also accepts no liability for the consequences of any actions taken on the basis of the information provided. The slides of this presentation cannot be taken separately from the whole set of slides. Prior approval from QuantInsti is necessary before usage of this presentation for educational and (or) commercial purposes. This document provides an outline of a presentation and is incomplete without the accompanying oral commentary and discussion.

45 Option Trading Techniques: A Trader s Approach for a Retail Investor Option Trading Strategies Rajib Ranjan Borah & Nitesh Khandelwal QuantInsti Bangkok, 6 Oct 2014

46 Option Strategies basic strategies Directional Volatility Time Value Hedging Volatility Spreads Option Arb Directional strategies: Long / short call Long / short put Long / short call(/bull) spread buy lower strike, sell higher strike Long / short put(/bear) spread sell lower strike, buy higher strike Correlation Dividend Long / short combo call at higher strike, put at lower Borrowing Tool

47 Option Strategies basic strategies Directional Volatility Time Value Hedging Volatility Spreads Volatility strategies: Long / short straddle Put and call of same strike Long / short strangle OTM Put and call of different strikes Long / short gut ITM Put and call of different strikes Option Arb Correlation Dividend Borrowing Tool Long / short butterfly Buy wings and sell ATM or vice versa Long / short condor Buy farther away OTMs and sell nearest OTMs or vice versa Long / short iron butterfly Buy straddle & sell strangle

48 Option Strategies basic strategies Directional Volatility Time Value strategies: Time Value Hedging Volatility Spreads Option Arb Correlation Dividend Borrowing Tool Long / short calendar spread (a.k.a. horizontal trades) Sell near expiry options, buy far expiry options Long / short diagonal calendar spread Same as above but different strikes Interest Plays Sell underlying and deep ITM puts Earn interest on cash from selling

49 Option Strategies basic strategies Directional Volatility Time Value Hedging Hedging strategies Protective Calls Short underlying hedged using long OTM call Protective Puts Long underlying hedged using long OTM put Volatility Spreads Option Arb Correlation Dividend Borrowing Tool Covered Call Writes Long underlying to cover short OTM call Short underlying to cover short OTM put Fences or Collars Combining Protective option with covered writes Long Underlying + Long OTM puts + short OTM calls

50 Option Strategies volatility spreads Directional Volatility Time Value Hedging Volatility Spreads Option Arb Correlation Dividend Borrowing Tool Backspread (also known as ratio backspread / long ratio spread) Delta neutral spread consisting of more long options than short Options with lower delta purchased Options with higher delta sold Ratio Vertical Spread (also known as ratio spread, short ratio spread, vertical spread or front spread) Basically the opposite of backspreads Options with higher delta purchased Options with lower delta sold

51 Option Strategies volatility spreads Directional Volatility Volatility Curve Skew Trades Time Value Hedging Volatility Spreads Option Arb Correlation Risk Reversal (a.k.a. risky) Long OTM calls + Short OTM puts Often a bet on vol curve skew Advanced Volatility Spreads: Forward Volatility Based Spreads Volatility for forward periods Dividend Borrowing Tool

52 Option Strategies simple option arbitrages Directional Volatility Time Value Conversal: Synthetically short underlying + long underlying (Short call + long put) underlying + long Hedging Volatility Spreads Option Arb Correlation Dividend Reversal: Synthetically long underlying + short underlying (Long call + short put) underlying + short In both cases, risks are minimal (Except dividend & interest rates exposures. Or pin risks for stock settled options) Borrowing Tool

53 Option Strategies correlation & dispersion Directional Volatility Time Value Hedging Volatility Spreads Option Arb Correlation Dividend Dispersion: Index constituted of a basket of stocks Implied volatility of index options should therefore be linked to implied volatility of stock options (of stocks making up the index) Dispersion trading is a way to trade Implied Correlation between volatility of index and index components i.e. bet on the degree to which constituent stocks disperse Borrowing Tool

54 Option Strategies correlation & dispersion Directional Volatility Time Value Dispersion (contd) The volatility of a basket with two assets is Hedging Volatility Spreads Option Arb Correlation Dividend Where ρ is the correlation coefficient Volatility of a basket with n assets will be Instead of n.(n-1)/2 correlations for a basket of n stocks, define a single average correlation Borrowing Tool

55 Option Strategies correlation & dispersion Directional Volatility Time Value Hedging Volatility Spreads The strategy becomes: Buy index volatility & sell component volatility when correlation is towards lower band Do reverse when correlation is towards upper band Option Arb Correlation Dividend Borrowing Tool

56 Option Strategies advanced option arbitrages Directional Volatility Time Value Dividend Plays Buying underlying and selling deep ITM calls Hedging Volatility Spreads Option Arb Skew Dividends Dividend expectations at different underlying levels Correlation Dividend Borrowing Tool

57 Option Strategies advanced option arbitrages Directional Volatility Time Value Hedging Volatility Spreads Option Arb Boxes: A conversal at one exercise price/strike A reversal at another exercise price/strike Long box = Synthetically long the lower exercise price Synthetically short the higher exercise price What would be the price of a 90/100 box? Value of box at expiry (=10) carrying costs Correlation Dividend Often cheaper way of borrowing funds from the market Borrowing Tool

58 Option Strategies advanced option arbitrages Directional Volatility Time Value Hedging Volatility Spreads Jelly Rolls: A synthetic long position in one expiry A synthetic short position in another expiry Long jelly roll = Synthetically long the near expiry options Synthetically short the far dated expiry options Option Arb Correlation Dividend What would be the price of a 90/100 Jun/Sep jelly roll? Value of roll = cost of holding underlying for the 3 month period from Jun to Sep. Borrowing Tool

59 Options Trading Techniques: A Trader s Approach for a Retail Investor Managing Option Portfolios Rajib Ranjan Borah & Nitesh Khandelwal QuantInsti Bangkok 06 Oct 2014

60 2 Risk Evaluations First order risks: Delta i.e. change in option price with change in underlying price Vega i.e. change in option price with change in underlying volatility Theta i.e. change in option price as time to expiry reduces Rho i.e. change in option price with change in interest rates Second Order risks Gamma ( change of Delta with change in Underlying price) Vanna ( change of Delta with change in Volatility) Charm ( change of Delta with change in Time) Vomma ( change of Vega with change in Volatility) Veta ( change of Vega with change in Time) Change of Vega with change in Underlying price Vera (change of Rho with change in Volatility)

61 3 Risk Evaluations Third order risks: Color (change of Gamma with change in Time) Speed (change of Gamma with change in Underlying Price) Zomma (change of Gamma with change in Volatility) Ultima (change of Vomma with change in Volatility) Other risks Rega - Volatility curve skew Sega - Volatility curve wings Forward Volatility (Volatility between two expiry periods) Skewed gamma (change in Gamma with change in volatility curve skew) Skewed delta (change in Delta with change in volatility curve skew)

62 Options price is dependent on price of underlying Price of Call Option vs Price of Underlying 4 4

63 Delta 5 The Hedge Ratio Equivalent Underlying Position Rate of change of price of option to change in underlying Probability of option finishing in the money 5

64 Delta 6 i.e. Delta is dependent on underlying price, time to expiry volatility 6

65 Delta vs Underlying Price Delta vs Underlying price/moneyness 7 7

66 Delta vs Time Call Delta vs Time left to expiry 8 8

67 Delta vs Time Put Delta vs Time left to expiry 9 9

68 Delta vs Underlying Price & Time Combined Visualization 10 10

69 Delta vs Volatility Call Delta vs Volatility 11 11

70 Delta vs Volatility Put Delta vs Volatility 12 12

71 Gamma 13 As we have seen, deltas change with underlying price (more so towards expiry) Gamma is the second derivative of the change of option price with respect to change in underlying price = 2 C/ S 2 = Δ/ S = N (h)/ (Sσ t) 13

72 Gamma vs Price of Underlying Gamma vs Price of Underlying 14 14

73 Gamma vs Time / Volatility Gamma vs Time 15 15

74 Gamma vs Underlying Price & Time / Volatility Overall impact 16 16

75 Gamma vs Time / Volatility Gamma vs Volatility 17 17

76 Lambda / Gearing 18 Delta is a poor estimate because unit change in underlying varies from underlying to underlying Lambda gets change in option price to a percentage change in the underlying 18

77 Dual Delta 19 Rate of change of price with respect to strike Strike 100, price = 10 Strike 120, price = 12 Dual delta = (12-10)/( ) = 2/20 = 0.1 Relationship between delta & Dual Delta Delta = 1/ Stock Price * (Option Price Strike * DualDelta) 19

78 Speed 20 Change in Gamma with respect to change in underlying Also known as gamma of the gamma 20

79 Color / Gamma decay 21 Change in Gamma with respect to change in time As seen previously: color is highest near the date of expiry and for ATM strikes 21

80 Vega 22 Change of option price with respect to change in volatility = C/ σ = S t N (h) = P/ σ 22

81 Option Price vs Volatility Option price at different volatility levels 23 23

82 Vega vs Underlying Price Vega at different strikes 24 24

83 Vega vs Time Vega of an option with varying time left to expiry 25 25

84 Vega vs Volatility Sensitivity to volatility is sensitive to volatility itself 26 26

85 Vega vs Underlying Price & Time/Volatility 27 27

86 Vega & Gamma 28 Long call or long put = Long vega = Long gamma as well Long vega & long gamma require volatility to profit Vega = S t N (h) = S t N (h). tσsn (h) / ( tσsn (h)) = S t N (h). tσs/n (h).(n (h) / ( tσs)) = S t N (h). tσs/n (h).(gamma) = S 2 tσgamma 28

87 Calibrating different Vegas 29 Different expirations will react differently to changes in perception of future volatility Long term volatility expectation is fairly stable but short term is not Vegas for different months need to be weighted differently to get net vega across expiries n Modified Vega = Vega i. Weightage i i 1 How to calculate Weightages? 29

88 Calibrating different Vegas 30 How to calculate Weightages? Empirical (based on observed historical volatility for different time periods) Theoretical/ square root weightages. Weightages proportionate to But is being weighted neutral enough? Forward volatilities 30