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Volatility Handbook
An Explanation of Basic Concepts, Strategies for Hedging and
Enhancing Portfolio Return, and Compilation of Selected Prior
Volatility Research

James J. Hosker
Amit Dholakia

February 2002

I. Introduction to Volatility
II. Volatility Concepts and Terminology
III. Trading Volatility
IV. Derivatives Trading Regulation and Market Structure

Volatility Handbook

Derivatives: The Key to Risk Management
There comes a point when a market observer begins to see beyond buy and sell, long
and short, black and white and perceives a more refined picture of the equity universe.
Degrees of bullishness and bearishness appear, and the observer wishes to align these
views with appropriately corresponding strategies. The risk of owning a stock outright
might seem too great or the leverage not enough. It is at this point that the observer can
make use of derivative instruments.
This guide is intended to be one building block in an education on derivatives. It is
meant as an introduction and a reference.
providing a working understanding.

Topics are discussed with the goal of

Readers are encouraged to access the Lehman

Brothers catalog of research to gain a more thorough understanding of individual topics.
A derivative is a financial instrument whose value is determined by an underlying asset or
benchmark. Assets and benchmarks range from corn crops, to the S&P 500, to the
Florida hurricane season. In short, derivatives can be tied to just about anything that
produces measurable results. This report is primarily concerned with equity and equitybased index derivatives, although the concepts are directly applicable to all types of
Originally, the term “derivative” applied only to transactions based upon an underlying
asset in which no money changed hands at the initiation of the contract. Forwards,
futures and swaps are examples of such instruments. Over time, the term derivative has
become associated with such products as options and exchange-traded funds and such
techniques as program trading. The common link between all of these concepts is that
they are a means of customizing risk exposure to match a view of the underlying. It is
this dynamic ability that makes derivatives extremely relevant in fashioning customized
payoffs and in controlling investment risk.
Understanding volatility is basic to an understanding of derivative securities. In this
handbook, we describe and develop the concept of volatility, discuss option strategies to
implement specific market views, and allude to pertinent derivative trading regulation and
market conventions that govern option trading. Finally, we provide a selected list of our
prior introductory research in this area.


February 2002

Volatility Handbook

Table of Contents
Derivatives: The Key to Risk Management ......................................................
................................ ...................... 2
Defi nitions of Volatility ................................................................
................................ ...............................................
................................ ............... 6
Historical Volatility ........................................................................................... 6
Implied Volatility .............................................................................................. 6
Option Premiums: Paying for Potential ................................................................. 7
Single Stock and Equity Index Derivatives:
Derivatives: Futures and Options ........................... 8
Description of Equity Index Futures...................................................................... 8
Description of Equity Options ............................................................................ 9
Factors Affecting Option Pricing ....................................................................... 10
Comparison of Futures and Options ................................................................. 11
Interpreting Implied Volatility ................................................................
................................ .....................................
................................ ..... 14
Term Structure of Implied Volatility .................................................................... 14
Strike Structure (or Skew) of Implied Volatility...................................................... 15
Real-Time Implied Volatility Market Indicators...................................................... 19
Volatility Cones ............................................................................................. 21
Option Strategies to Trade Volatility ............................................................
................................ ............................ 24
New Developments in Equity Derivatives: The Excha
nge Traded Fund (ETF) .......... 28
Investment Strategies Using Exchange-Traded Funds ............................................ 28
Conclusion ................................................................................................... 35
List of Available ETF’s on Selected Indices.......................................................... 36
CostCost -Effective Trading: A Look at NasdaqNasdaq-100 Derivative Products ..................... 39
Market and Exchange Details ................................................................
................................ ....................................
................................ .... 44

February 2002


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February 2002

Volatility Handbook Section 1: Introduction to Volatility February 2002 5 .

Conversely. volatility is defined as the standard deviation of expected returns. Implied Volatility Implied volatility is a forward-looking measure of the expected volatility level that is implicit in option prices. not the direction of the change. It reflects the degree to which an asset’s value changes relative to its mean over a given number of observations. thereby trading on a view that volatility will eventually decrease.M )2 i =1 n -1 where: Xi = observation M = sample mean n = number of observations Realized volatility aims to analyze historical price fluctuation to anticipate future performance.Volatility Handbook Definitions of Volatility Historical Volatility In statistical terms. the rich premium associated with options on a volatile asset may be desirable to an option seller who looks to absorb the premium by selling the option. Finally. which gauges the market’s perception of a contract’s volatility. volatility measures the degree of variability. High volatility in the underlying asset is desirable to an option buyer. Examining the sensitivity of implied volatility to changes in option expiration and strike price provide valuable insights for structuring an option strategy. The calculated price can be used to determine a theoretical level of option implied volatility. attempts to quantify a range for an asset’s future volatility. In the case of 6 February 2002 . or implied volatility examined over short. but the buyer will have to pay for this volatility in the form of a higher premium. An option-pricing model. such as the Black-Scholes model. Historical or realized volatility is a backward-looking measure that attempts to quantify an asset’s price fluctuation over a given time frame in the past. Term structure. An option on a highly volatile underlying security will tend to have a high implied volatility as well. implied volatility. Realized volatility is calculated according to the following formula: n Realized Volatility = å (X i . Volatility has value. because the option has a greater likelihood of expiring in-the-money. volatility measures the degree of price fluctuation over a specific period of time. can determine a theoretical price for an option using other parameters to characterize the underlying asset. While historical volatility is calculated based on an asset’s prior price fluctuations.

as highly volatile underlying assets are more likely to reach far in-the-money and out-of-the-money strikes. and the call premium will be higher than it would have been if the underlying stock were less volatile. then the chance of the call being inthe-money will be greater. ITM = in-the-money. what is it worth? To determine an accurate option premium. by which time the underlying asset value may have changed to a level that makes option exercise profitable. As mentioned above. reveals the option market’s expectations for volatility going forward. which is true of all out-of-the money options by definition. OTM = out-of-the-money February 2002 7 . put options. Option Premiums: Paying for Potential Option premiums have two separate components: intrinsic value and time value. If the call strike is currently greater than the price of the underlying. Although an option may not currently have intrinsic value. Strike structure reflects the option market’s assessed probability that different option strike levels will be reached by an underlying asset before expiration. This makes sense when thought of in terms of the underlying asset.Volatility Handbook long-term expirations. the more exclusively its price is based upon volatility. For equity calls and puts. the call is said to be in-the-money (ITM). a highly volatile underlying asset has a greater Term and Strike Structure of Implied Volatility 1 probability of reaching far in-the-money and out-of-the-money (OTM) strikes before expiration. We explore term and strike structure in greater detail in Section 2. which give the holder the right to sell the underlying asset at the strike price. because its price tends to fluctuate in a very wide range. further out-of-the-money options tend to have higher implied volatility compared to near-the-money strike options. Underlying asset volatility is a key component in determining strike structure. we first need to answer another question: what is the likelihood that the call will ever be in-the-money? If the price of the underlying stock is extremely volatile. the option is still has time value as it is valid until the expiration date. then the call option has no intrinsic value and is an (OTM) option. If Call ABC on stock XYZ is $15 out-of-themoney. Intrinsic value is the amount of profit that can be collected by buying an option and exercising it immediately. 1 We use the following conventions to refer to option strike prices throughout this document: ATM = at-themoney. Implied volatility will reflect this probability. If a call option’s underlying asset value exceeds its strike price. this is the amount by which the price of the underlying asset currently exceeds the option strike price. are in-the-money when the option strike exceeds the current underlying asset price. For a call option. Conversely. It is in the time value component of the option premium that implied volatility plays its role. The further an option is out-of-themoney.

Since indices contain many stocks that usually provide dividends at different times. Liquidity in futures contracts is generally generally concentrated in the nearestnearest-term month (the closest expiration from the present). Prentice-Hall Inc. which allows for standardization in contract specifics such as size. the spread between the nearestterm contract and the next closest expiration. 2000. Options. As expiration approaches and futures roll activity picks up. but are not commonly offered for individual Futures Roll or Calendar Spread equities. We provide the formula for calculating the price of a futures contract on an equity index.2. Generally. expiration and delivery method. such as a stock or an equity index. 4th Edition. Assuming that the maturity of the futures contract is the same as the duration of the required hedge. we make the simplifying assumption that the index can be treated as an asset with a continuous dividend yield. the optimal amount of futures contracts needed to hedge depends on three criteria: the dollar amount of the portfolio. futures are generally available on indices and 2 some exchange-traded funds (ETF’s).. the portfolio beta relative to the market and the dollar amount of assets that underlies each futures contract. T : time to expiration Equity index futures are particularly effective tools to hedge risk in diversified portfolios. Futures contracts are normally traded on an exchange. financial instruments whose value is dependent upon an underlying variable that is often a traded asset. Futures and Other Derivatives. Equity Index Futures Price Calculation 3 (r – q) * T F0 = S0 * e(r – q) * T where F0: futures price S0: current index level r: continuously compounded risk-free rate q: annual index dividend yield. Within the equity market. a portfolio with a higher beta will require more futures contracts to hedge. present) which causes investors wishing to maintain their current futures position to “roll” it forward to the next expiration. and illustrate its use as a hedging vehicle.Volatility Handbook Single Stock and Equity Index Derivatives: Futures and Options Description of Equity Index Futures Futures and options are two basic examples of derivative products. spread becomes an important profit-and-loss consideration. 2 3 A complete introduction to ETF’s is available in Section 3. John C. 8 February 2002 . known as the calendar spread. As defined in: Hull.

ExchangeExchange-traded options have standardized expiration dates and strike prices. whereas the more flexible American options can be exercised at any time up to expiration. 4 As defined in: Hull. European options can be exercised only on the expiration date. derivative instruments offered on individual stocks. Futures and Other Derivatives. Description of Equity Options 5 Equity options. At the most basic level. 2000. Depending on the underlying asset. 4th Edition. there are two types of options options: n Call Option: Gives the holder the right to buy the underlying asset by a certain expiration date for a certain strike price. Prentice-Hall Inc...Volatility Handbook Calculating Number of Futures Contracts for Hedge Hedge 4 # of contracts needed = b * PDV/AV where: b: portfolio beta relative to market PDV: PDV portfolio dollar value AV: AV asset value underlying each futures contract As the formula shows. 5 IBID February 2002 9 . John C. Options. but customized options can be created and traded in the OTC market. exercised options can be settled through delivery of cash or an equivalent amount of the asset itself (called physical settlement). beta) even if the dollar value of the portfolio does not change. baskets of stocks.e. contract specifications and exchange information. are commonly traded on exchanges and in the more unofficial overthe-counter (OTC) market. n Put Option: Gives the holder the right to sell the underlying asset by a certain expiration date for a certain strike price. indices and ETF’s. the number of futures contracts required to hedge increases with portfolio portfolio volatility (i. Our comprehensive Handbook of World Equity Index Futures in Section 3 of this publication provides a list of available index future. trading regulations.

Figure 1: Parameters Affecting Option Pricing Delta (D (D) Change in option price resulting from an incremental change in the price of the underlying asset. which lower the asset price on the ex-dividend date. The following table summarizes the effects of each parameter on the option price (or option premium). Rho (R ( R) Change in option price resulting from an incremental change in the riskrisk. The early exercise feature of American options makes the possibility of dividend payment immaterial. which can lower the stock price. Delta is positive for long call options and negative for long put options. Hull Within the equity universe. Option sensitivity to each parameter is measured by taking the partial derivative of the underlying asset’s return function with respect to that particular variable. have a negative effect on the value of call options and a positive effect on the value of put options. Rho is positive for long call options and negative for long put options. An option’s delta is a function of the underlying asset price and the option strike price price. as the holder would simply exercise prior to the scheduled payment date. 10 February 2002 . Figure 2: How Option Prices are Affected by an Increase in Parameter Value Increase in European Call European Put American Call American Put + - + - Strike Price - + Time to Expiration ? ? Underlying Asset Volatility + + + + + + + Risk-free Financing Rate + - + - + - + Underlying Asset Price Dividends - th Source: Options. Source: Options. Vega (V) Change in option price with respect to volatility of the underlying asset value. The value of Gamma is higher for at-the-money. At expiration itself. due to higher time value. Gamma (G (G) Change in option price resulting from an incremental change in Delta. the value of Theta is zero. dividends paid out by an underlying stock or index. One day before expiration. Theta (Q (Q) Change in option price with respect to time remaining remaining till expiration. Futures and Other Derivatives – 4 Edition by John C. makes the overall effect ambiguous. Vega increases as time to expiration increases and is higher for at-the-money strikes. short-dated financing rate. Measures the sensitivity (or convexity) of delta relative to the change in the underlying asset price. but the dividend payment. Each option parameter is conventionally represented through a Greek letter and summarized in Figure 1. Hull In most cases. Futures and Other Derivatives – 4th Edition by John C. Theta increases as time to expiration decreases. increasing the time to expiration will increase the premium of European calls and puts. the value of Theta is equal to the value of the underlying asset at that time.Volatility Handbook Factors Affecting Option Pricing There are five parameters (or variables) that affect the price of an option.

which is known as the option premium paid by the buyer. availability of standardized contract conventions. An investor may enter into a futures contract without cost. There is a cost to acquiring an option. but the holder can choose whether or not to exercise that right.Volatility Handbook Comparison of Futures and Options Futures and options are similar in their derivative nature. and sensitivity to time. or let the option expire. we compare the payoffs from long and short positions in equity futures and options positions in Figure 3. options opt ions give the holder the right to buy or sell an underlying asset. Finally. whereas an option contract is not. Conversely. February 2002 11 . cost but he is bound to buy or sell the underlying asset at the contracted price within the specified delivery period period. There is one important difference between the two: A futures contract is binding with respect to the underlying asset.

we discuss the benefits of options strategies that use combinations of calls and puts to translate market and volatility views into trading positions. 12 February 2002 . shorting a call option (without a position in the underlying) can cause unlimited risk. In Section 3. Long Call Option Position Payoff Short Call Option Position Payoff O ption P rem ium C ollected O ption P rem ium P aid Strike P rice P lus P rem ium Long Put Option Position Payoff Strike P rice P lus P rem ium Short Put Option Position Payoff O ption P rem ium C ollected O ption P rem ium P aid Strike P rice M inus P rem ium Strike P rice M inus P rem ium Source: Lehman Brothers It is evident that options offer investors more flexible ways to limit downside risk while maintaining upside profit potential. Conversely. The downside risk of buying an option is limited to the premium paid. which is mitigated slightly by the premium collected from the sale. Shorting a put option also provides a premium and has limited risk to the point where the underlying asset loses all value. Short Future Position Payoff Long Future Position Payoff A ssetP rice at M aturity A ssetP rice at M aturity D eliveryP rice D elivery P rice Long option positions offer the upside benefit of futures with much lower risk.Volatility Handbook Figure 3: Payoffs from Equity Futures and Equity Options Contracts Futures have linear payoffs where a long position has unlimited upside and a short position has unlimited downside.

Volatility Handbook Section 2: Volatility Concepts and Terminology February 2002 13 .

provide comprehensive definitions of both concepts.Volatility Handbook Interpreting Implied Volatility Two important characteristics of implied volatility are its variation patterns over time. In this section.0% . Bloomberg 14 February 2002 9/ 2/ 01 10 /2 /0 1 11 /2 /0 1 12 /2 /0 1 8/ 2/ 01 7/ 2/ 01 6/ 2/ 01 5/ 2/ 01 4/ 2/ 01 3/ 2/ 01 2/ 2/ 01 1/ 2/ 01 15. while the 1-year contract is the least variable. 6-month and 1-year option contracts on the S&P 500 in 2001.0% 17. Figure 4 shows the daily implied volatility of 3-month. The 3-month contract in Figure 4 shows the greatest variability. long-term mean reversion is an appropriate characteristic of implied volatility. Intuitively. Term Structure of Implied Volatility Term structure characterizes option value over time and helps determine the ideal time horizon over which a strategy may be executed.5% Source: Lehman Brothers. structure). Conventionally. As volatility is measured over longer terms. the term structure is charted from the nearest month expiration. uncertainty is large enough to eliminate any forecasting accuracy for longer-term implied volatility. suggesting the tendency of implied volatility to revert to its mean value over the long term. we structure and across strike prices (strike structure) Implied volatility measures market perceptions of volatility. Implied volatility forecasts become less accurate as the time frame for the forecast increases. Figure 4: S&P 500 Implied Volatility Term Structure in 2001 Shorter-term contracts are also the most variable. the best possible estimate for longer-term implied volatility is its average value over time. Conventionally.5% 25. 3-mth 6-mth 1-yr 30.0% 27. respectively. which means that both gauge market perception of future volatility levels across time and strike.5% 20. While even short-term volatility forecasts cannot account for all possible driving factors. called term structure. and illustrate their significance to option pricing and strategy. indication of the market’s volatility expectations. which provides the clearest Importance of the near-term contract. It is important to remember that term and strike structure involve the implied volatility measure. it tends to revert to its mean value.0% 22.

1% 27.8% 16.2% 3-Yr Avg +2 SD 27. volatility is the only option parameter not observed or calculated.6% 21. and can indicate changes in the option market’s expectations for volatility over the long and short term.3% 19.4% 19. Bloomberg Strike Structure (or Skew) of Implied Volatility The strike price of an option affects its sensitivity to price changes in the underlying asset.9% 19.9% 21. For example.3% 18.9% 20.3% 27. The divergence in implied volatility levels allows us to reasonably 6 Graph shows a snapshot of term structure as of Feb 5.9% 26.3-Mth Term Slope of Impl Vol 3-Yr Current 19. however.3% One Week Ago 21.5% 29.3% 20. but is instead implied by the theoretical market price of the option.Volatility Handbook The following graph shows the term structure of S&P 500 implied volatility over the short and long terms.1-Mth Term Slope of Impl Vol 30% Current Avg SD SD Units Postive/Negative Slope 25% 0.9% 17.1% 2.9% 18.6% 17.1% 19.2% 1. if the market begins to expect increased volatility in the S&P 500 in the near term.5% 22.7% 1.7% 21. the implied volatility of 1-month and 3-month contracts will rise relative to longer-term contracts. a relationship characterized by the option parameter Delta.5% 30.1% 3-Yr Avg -2 SD 14.9% 20.7% 19.9% 28. We examine only atat -thethe.2% 19.4% 20. Mathematically. Expectations of higher near-term implied volatility will cause the term structure differential between 1-year and 3-month implied volatility (shown in the lower table in Figure 5) to decrease.1% 21. the term structure might be flatter for longer-dated contracts. which results in various levels of implied volatility that is observable in the market for any given option contract.6% 26.7% One Month Ago 16.2% 19. Figure 5: Term Structure of At-the-Money Implied Volatility of the S&P 500 35% 6 Term Structure of ATM Impl Vol 3-Mth . 2002.3% 18.9% 21.6% 19.0% -0. If expectations are that volatility will not Term structure reveals the option market’s expectations for future volatility over time.2% 20. rise beyond a few months.97 Fairly Negative 20% 15% 10% 1-Mth 2-Mth 3-Mth 4-Mth 6-Mth 9-Mth 1-Yr 2-Yr 1-Yr . has a different perception of future volatility. term structure differentials measure the slope at any point along the term Term structure differentials measure the slope at any point along the curve.9% 19.5% 19. For a daily update of global index term structure.1% Source: Lehman Brothers.7% -0. As mentioned earlier. structure curve. Each market-maker.9% 20. February 2002 15 .0% 20. contact your Lehman Brothers sales representative. The option premium associated with a certain strike price is a function of the implied volatility of the underlying asset. keeping the option delta at each strike level constant to isolate the effects of term structure.4% 1.9% 27.18 Normal Current Avg SD SD Units Postive/Negative Slope (ATM) strikes.4% 20.0% 20.5% 18. which is derived through a theoretical pricing model such as the Black-Scholes Model.

Volatility Handbook infer that the options market. Figure 6: Strike Structure of Implied Volatility for Single Stocks (Volatility Smile) ATM Strike Implied Volatility Implied volatility increases for OTM puts Implied volatility increases for OTM calls Source: Lehman Brothers 7 8 Natenberg. does not consider that model to be completely efficient. and increases as strikes are set further out-of-the-money on both the call and put side. The “volatility smile” effect is observed only for some single stocks and is not a feature of index options. since large price movements are also almost equally likely in 8 either direction. which has an equal likelihood of large price movements in either direction. For single stocks. Strike structure of single stock options. while relying on some theoretical pricing model as a starting point. The “volatility smile” shape shows that option markets believe large stock movements are likely events. We compare and contrast index option skew patterns with the “smile” pattern in the following pages. Consequently. which exhibit negative skew. and that price movements are almost equally likely to occur in either direction (strike structure is similar for single stock call and put options). 7 The general shape of implied volatility skew. implied volatility increases for further OTM strike prices. 16 February 2002 .” indicates the market’s belief that large movements in stock price occur with more regularity than a theoretical pricing model would predict. Figure 6 shows the generic strike structure of implied volatility. Sheldon. often called a “volatility smile. which makes OTM options valuable. 1994. making OTM options more valuable. implied volatility of some single stock options that follow this pattern is lowest for the ATM strikes. Option Volatility and Pricing. McGraw-Hill & Co.

9% 13.6% 25. Figure 7: Implied Volatility Strike Structure of 3-Month S&P 500 Options 40% 3-Month Strike Structure of Impl Vol 3-Month 90% . 9 Current Avg SD SD Units Steep/Flat Indicator 5. stocks tend to drop together in falling markets more often than they increase together in rising markets) 9 Graph shows a snapshot of 3-month strike structure as of Feb 5.2% 3-Yr Avg +2 SD 38. 2002.1% 0.54 Fairly Steep 20% 15% 10% 80% Strike 90% Strike 100% Strike 110% Strike 120% Strike Current 31.9% 14.4% 17.2% One Month Ago 30.6% 17. The negative skew of index option implied volatility means that the market believes that index prices are much more 10 likely to swing down than up. due to subtle differences in the way the market views the likelihood of large price swings occurring for stocks versus indices.8% 13.2% 3-Yr Avg -2 SD 26.7% 5. When the market views large upside and downside moves as being equally likely.7% -0. which shows an underlying market belief that a price swing to the downside is much more likely than to the upside.1% 1.2% 19. Indices are thought to have a greater probability of downside price movements.6% 8.6% 21. 1994.9% 20.3% 16. February 2002 17 . We define strike prices as a percentage of the underlying asset value (thereby making the 100% strike equivalent to the ATM strike).2% One Week Ago 29.2% 20. contact your Lehman Brothers sales representative.2% 1-Month 90% ..e. equity index options exhibit a downward sloping strike Strike structure of equity index options structure that is highest for the OTM strikes and decreases as the strike prices move inin-thethe-money.6% 24. implied volatility skew takes on a balanced “volatility smile” shape.6% 14.1% 21.100%Strike Skew of Impl Vol 35% 30% 25% The differentials shown on the right describe the slope of the curve between the 90% and 100% strike.Volatility Handbook Implied volatility strike structure for equity index options usually does not follow the same pattern as described above for some individual stock options. which is expressed in the negative skew of index option implied volatility. For a daily update of global index strike structure. Sheldon.100% Strike Skew of Impl Vol Current Avg SD SD Units Steep/Flat Indicator 6.2% 16.1% 15.9% 22. McGraw-Hill & Co. As Figure 7 illustrates.6% 32. A steep slope indicates a large drop in implied volatility between the strike prices.1% 2.. Option Volatility and Pricing.6% 26.8% 25.56 Fairly Flat Source: Lehman Brothers Strike Structure Differences Between Between Single Stock Options and Equity Index Options We have thus far concluded that strike structure of implied volatility is determined by market perception of the likelihood of large price movements in either direction. This strike structure pattern is known as negative skew. 10 Natenberg. but why? Two reasons have been offered : n Stock markets and sectors have a larger downside correlation than upside Why does index option strike structure differ from single stock option strike structure? correlation (i.

Volatility Handbook n Stock index options are very commonly used to hedge long equity portfolios. Biotechnology (BTK). 11 See Longin F.4 7/27/01 10/27/01 4/27/01 1/27/01 7/27/00 10/27/00 4/27/00 1/27/00 10/27/99 7/27/99 4/27/99 1/27/99 7/27/98 10/27/98 4/27/98 1/27/98 7/27/97 10/27/97 4/27/97 1/27/97 7/27/96 10/27/96 4/27/96 1/27/96 10/27/95 0. making demand for put options much higher than call demand.8 0. 18 February 2002 . The nine sector indices are Banks (BKX). and consequently raising index put premiums relative to call premiums. Cyclicals (CYC). This asymmetry in market correlation causes the negative implied volatility skew present in index options. sector correlation is higher during periods of 12 negative return .6 0. 649-676. 2001. which is associated with falling returns. Figure 8 plots the average downside and upside inter-sector correlation for nine 13 market sectors and the S&P 500 index option implied volatility from October 1995 to October 2001. “Extreme Correlation of International Equity Markets. 2001.2 Source: Lehman Brothers As we stated in our earlier analysis. the graph in Figure 8 suggests that average upside and downside sector correlation move together except in periods of low or high option implied volatility. Downside Ups ide High implied volatility and high downside correlation 1. 2001. such as October 1997 and August 1998 (Southeast Asian Crisis and Russian debt crisis respectively). Semiconductor (SOX).0 0. Solnik. issue of The Outlook.” in November 12.” Journal of Finance. Asymmetrically high put demand and put premiums will skew put implied volatility to the downside for index options. Pharmaceuticals (DRG). when downside correlation spikes. Broker/Dealer (XBD) and Utilities (UTY). Specifically. Figure 8: Average Sector Index Downside and Upside Correlations from October 1995 to October 2001 Market During periods of high market implied volatility. which leads to different volatility implications for single stocks and indices. We explore the arguments for greater index downside skew: Extensive prior research has suggested an asymmetric correlation in equity sector returns 11 during bull and bear markets. 12 13 See “Not All Momentum Sectors are Created Equal. High Technology (MSH). and B. From a prior analysis conducted on November 12. 56. The average inter-sector correlation is a 22-day moving average of the 36 pair-wise inter-sector correlations. Consumer Staples (CMR). Our analysis used a 22-day period (calendar month) to calculate inter-sector correlation. market correlation is higher than on the upside.

16 Uses NDX options and the same construction methodology as the VIX. For example. precisely because of the greater index tendency for downside moves.Volatility Handbook Indices exhibit asymmetric return distributions that are historically skewed to the negative tail. The discrepancy between index and single stock option strike structure volatility occurs on the put side. This perceived asymmetric downside index tendency raises the value of OTM index puts and lowers the value of ITM puts. 14 Examined together. skew can help identify the appropriate strike prices based on market expectation of relative volatility. the VXN shows the higher implied volatility inherent in technology stocks. Extremely high VIX levels indicate high anxiety. While term structure is useful in identifying the ideal time horizon to execute a strategy. risk and uncertainty in the options market and generally coincide with a continued decline in stock prices. VIX increases as the market declines (showing higher implied volatility) and vice versa. 15 The VIX index replicates the payoff of a hypothetical ATM option expiring in 30 days. the thickness of the tails). and is often regarded by technical analysts as a contrary market indicator. Since it measures implied volatility. 16 VXN Index (shows implied volatility of Nasdaq-100) Similar to the VIX. because markets perceive single stocks to have a relatively equal chance of moving significantly up or down. The option is composed of eight puts and calls on the underlying OEX weighted by time to expiration and the ATM strike price. VIX Index (shows implied volatility of S&P 100) 15 The VIX was developed in 1993 as an indicator of market implied volatility. Real-Time Implied Volatility Market Indicators The Chicago Board Options Exchange (CBOE) offers real-time indices that track shortterm index implied volatility on the S&P 100 (OEX) and the Nasdaq-100 (NDX). meaning it moves inversely with the market. Single stock ITM puts have similar premiums to OTM puts.. these distributions also have a higher level of kurtosis than exhibited by a normal distribution. February 2002 19 . Compared to the VIX. which tracks the relatively more stable S&P 100 index. Low VIX levels signify low implied volatility and relatively complacent markets. have more downside risk than a single stock. 14 Kurtosis measures how much of a distribution’s variability lies at the extremes (i. negatively biased asymmetry and higher kurtosis imply that indices. the VXN Index gauges implied volatility on the Nasdaq-100. providing investors with a real-time volatility barometer for the technology universe. as empirical research would suggest. the strike structure in Figure 7 drops more steeply from the OTM strikes leading up to the ATM strike than it does after. Furthermore. which indicates that the market expects higher volatility (and higher premiums) on that portion of the skew curve.e.

0 Volatility (%) 60.0 50. but of the implied risk associated with the stock market. Put option implied volatility is the most likely to rise in a falling market as investors seek protection. which means that market declines are associated with higher overall levels of risk and higher implied volatilities. sector risk (and hence market risk) has an asymmetric negative bias.2.0 80.0 30. Implied volatility is not reflective of the size of price 17 swings.0 10.0 VXN Level Source: Lehman Brothers QQV Index (shows implied volatility of options on the Nasdaq-100 ETF) The Nasdaq-100 Index Tracking Stock (ticker symbol QQQ) is the most popular example of a relatively new investment vehicle known as an exchange traded fund 18 (ETF).0 40. is the volatility implicit in option prices. Figure 9: Daily 2001-2002 VIX and VXN Volatility Index Levels The VIX and VXN indices developed by the CBOE track implied volatility of the S&P 100 and Nasdaq-100 respectively. . Implied volatility.0 1 9/ 2/ 01 10 /2 /0 1 11 /2 /0 1 12 /2 /0 1 1/ 2/ 02 2/ 2/ 02 1 VIX Level 8/ 2/ 0 1 7/ 2/ 0 1 6/ 2/ 0 1 5/ 2/ 0 4/ 2/ 0 1/ 2/ 0 1 2/ 2/ 01 3/ 2/ 01 0. The QQV Index (quoted on the American Stock Exchange) was developed in September 2000 to track the implied volatility of options on the QQQ. 20 February 2002 17 From the CBOE website ( 18 ETF’s are introduced and described in Section 3.cboe. 90.0 20. and has an inverse relationship to the market. we can look no further than the VIX and VXN spike in Figure 9 caused by the additional risk that the events of September 11 injected into the markets. The methodology is similar to that used by the CBOE in calculating the VIX and VXN.0 70. As mentioned before. The two are regarded as barometers of implied volatility in the options markets. as earlier defined. For evidence of rising implied volatility in risky markets.Volatility Handbook A Note on Contrary Market Indicators It is important to clarify the relationship between VIX and VXN levels and market activity. the spike in put activity also causes premiums to rise.

7% 20.8% 21. The volatility cone in Figure 10 condenses implied and realized index volatility data.4% 15.1% 23.1 Mth-Realized) 10% Vol Sprd 3-Yr Avg Vol Sprd -2 SD Near-ATM Impl Vol 3-Yr Avg Vol Sprd 3-Yr Avg Vol Sprd +2 SD 20% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 15% 0% 10% 1-Mth 2-Mth 3-Mth 4-Mth 6-Mth 9-Mth 1-Yr 2-Yr 3-Yr Min Realized 9.4% 20.Volatility Handbook Volatility Cones Just as term and strike structure display market perceptions of implied volatility. which are susceptible to the widest fluctuations.6% 27.7% 21.8% 5% 0% -5% -10% -15% Current Realized 17.2% 20. 19 Graph provides a snapshot of S&P 500 historical and implied volatility as of February 6. volatility cones show technical and momentum trends in historical volatility over time.5% 20. Cones are also useful tools to compare relative volatility levels of two stocks or indices.8% 20.2% 17.0% 21.5% Current Implied 20.7% Source: Lehman Brothers Profitable relative volatility trades can be executed on discrepancies between implied and realized volatility or current and historical levels of realized volatility.9% 20. but the range narrows as the time horizon is extended.1% 26.1% 21.5% 30.8% 20. Figure 10: S&P 500 Implied and Realized Volatility Cone and Near-term Volatility 19 Spreads A volatility cone is useful in identifying trading opportunities caused by discrepancies in realized and implied volatility levels.6% 16.9% 20. Contact your Lehman Brothers Sales Representative for current levels.0% 19.9% 13.2% 17.2% 17. and shows nearterm volatility spread trends to make an effective trading tool.4% 20.8% 17.0% 17.4% 21.7% Avg Realized 19. 2002.1% 21.1% 11. The shape of a volatility cone illustrates the long-term mean reverting property of volatility.4% 20. The cone is widest for the near-term expirations. Near-Term ATM Implied Vol & Realized Vol Realized Volatility Cone & Current ATM Implied Vol 40% 45% 40% 1-Mth Realized Vol Near-ATM Impl Vol 35% 30% 30% 25% 20% 15% 10% 20% Vol Spread (Near-ATM Impl .6% 18.9% 19.4% 20.0% 20. February 2002 21 .5% 19.0% 12.8% 21.3% Max Realized 35.6% 28.3% 20.0% 24.

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Volatility Handbook Section 3: Trading Volatility February 2002 23 .

Volatility Handbook Option Strategies to Trade Volatility Most investors have a view on a single stock. 24 February 2002 . Options are an efficient and cost-effective way to implement trading positions designed to profit on an investor’s views on the market. sector or index and how they think its price will vary over a given future time frame. Figure 11: Option Strategies for Expectations of Momentum and Volatility Expect Price Increase Expect Increased Volatility Expect Stable Volatility Expect Price Stability Expect Price Decrease Buy Calls Buy Straddles or Strangles Buy Puts Bullish Spread Strategies Long-Short Strategies Bearish Spread Strategies Sell Puts Sell Straddles or Strangles Sell Calls Expect Decreased Volatility Source: Lehman Brothers The basic strategies outlined above can be combined to capitalize on current market conditions. we show appropriate option strategies to implement various views on underlying asset price movement and volatility levels. n Current and Future Volatility Levels: How high or low are current implied and realized volatility levels relative to each other? How high is current realized volatility relative to past levels of realized volatility? In Figure 11 below. We outline the mechanics of the basic strategies and possible combinations to profit from expected market and volatility movements in Figure 12. There are two basic factors that should help determine an appropriate strategy: n View on the Underlying Asset: What factors does the investor believe will drive the value of a stock or index over a given time period in the future? These could be fundamental factors or technical/momentum driven factors.

sell lower strike put Moderately bearish – willing to risk capital for downturn in underlying but not to the degree of outright put buying Put Credit Spread Sell high strike put. Call Credit Spread Buy high strike call. sell lower strike call Moderately bearish – seek to take in premium with limit to potential loss Put Debit Spreads Buy high strike put. uses less capital than buying the underlying outright. See little movement in underlying away from the strike in either direction. A collar is designed to protect a long position in the underlying. Call Debit Spreads Sell high strike call. The insurance put is financed. Short Strangle Sell a put and a call at different strikes (call strike above. reflecting the lower probability that the strike price will be hit before expiration. the appropriate strike price is critical. Collar Buy an out-of-the-money put and sell an out-of-the-money call. Option premiums decrease as strike prices get further out-of-the-money. Call Overwriting Selling calls with an existing long position in underlying Income strategy/Exit strategy – either take in premium or sell off long position at a favorable price. put lower) See movement in underlying away from range between strikes. which represents the upside potential of the underlying. See movement in underlying away from strike. at least partially. We outline a methodology for choosing OTM strike prices and the trade-off between income (cost) and downside protection (upside potential): February 2002 25 . Buy Puts Buying Puts Strongly bearish – a low cost short or insurance against loss on long position. Long Strangle Buy a put and a call at different strikes (call strike higher. buy lower strike call Moderately bullish – willing to risk capital for limited upside with less risk than outright call buying.Volatility Handbook Figure 12: Basic Description of Basic Option Strategies Strategy Name Strategy Components Possible Uses Buy Calls Buying Calls Strongly bullish – risks entire premium for upside movement in underlying. but not sure of the direction Short Straddle Sell a put and a call at the same strike price. put below) See price of underlying remaining within the range between strikes until expiration. but less profitable. Strategy can also be accomplished by simultaneously buying the underlying asset and selling calls to finance the purchase. Moderately bullish – seek to take in premium with limit to potential loss Long Straddle Buy a put and a call at the same strike price. Sell Calls Sell calls with no position in underlying stock Extremely bearish – unlimited risk potential since there is no existing position in the underlying asset. by the selling of the call. The risk is a potentially forced long position if sold put is exercised. Sell Puts Selling Puts Strongly bullish – entry strategy or potential income strategy. Potential entry strategy. Source: Lehman Brothers Selecting Appropriate Strike Prices for Out-of-the-Money Options The option strategies above are each combinations of call and put options with different relative strike prices If a desired strategy recommends buying or selling OTM strike options. Cheaper than long straddle but more risky. buy lower strike put. Less risky than short straddle.

Volatility Handbook Buying OTM Options: Strike price should be set at a level where the investor believes the premium paid is worth the potential upside and the probability that it will be reached. Figure 13: Illustrations of Option Strategy Payoffs Call Overw riting Call Debit Spread 26 February 2002 Collar Strategy Call Credit Spread . We provide graphical illustrations of the payoffs of the basic options strategies described above in Figure 13. Defensive-minded investors will likely opt to collect a lower premium by selling a further OTM option in return for the added protection provided by the higher strike. Sell OTM Options: Strike price should be set at the investor’s optimal trade-off between current income and protection.

Volatility Handbook Put Debit Spread Put Credit Spread Long Straddle Short Straddle Long Strangle Short Strangle Source: Lehman Brothers February 2002 27 .

It is a well known fact that asset allocation decisions are significant determinants of superior investment performance. Financial services. the QQQ’s have two-thirds the assets of SPDR’s (approximately $11 billion) but trade nearly twice the average daily dollar volume of the latter. In what follows. QQQ’s have quickly become one of the most actively traded securities on any of the U. tracks the performance of the S&P 500 index much like a mutual fund. QQQ’s traded slightly over 70 million shares a day in 2001. On average. Technology. The portfolio could represent either an entire market (such as the S&P 500.” September 15. Investment Strategies Using Exchange-Traded Funds ETF enabled investment strategy Part of the excitement surrounding the introduction of ETF’s is due to the facilitation of new investment strategies they make possible. Currently.) or even a selected basket of stocks. etc.S. sizes. The first ETF. Russell 3000. styles. and institutions own nearly 40% of SPDR shares. like a single stock. Real Estate. The obvious approach is to own the stocks in the benchmark index in a portfolio that is weighted according to the benchmark's weighting methodology. Brief History of ETF’s ETFs have grown in popularity since their origin in 1993. Telecommunication. Launched in March 1999.). . However. Although the current ETF’s track or replicate well-known market indices. a sector or industry of the market (Internet. Another widely popular ETF tracks the Nasdaq 100 index and trades under the ticker 22 symbol QQQ. ETF’s and Futures Contracts Equity asset managers that are benchmarked to a major index have alternative methods of investment to achieve the performance of their benchmark. 21 22 28 February 2002 SPDRs are managed by State Street Global Investors. By far the dominant ETF on the market today. making them one of the most liquid securities traded on any exchange. With a current estimated asset base of about $20 billion. stock exchanges. real world issues such as index 20 See “Exchange-Traded Funds: Where the Market is a Stock. we list potential investment strategies executed efficiently with ETF’s. SPDR’s have more than 40% of the market share of all ETF assets. known 21 as “spiders”). we establish the need for asset allocation strategies to achieve superior returns and to forecast asset returns In addition to asset allocation.Volatility Handbook New Developments in Equity Derivatives: The Exchange Traded Fund (ETF) What is an ETF? 20 An ETF is a hybrid security that is traded on an exchange. it has more than 100 million shares outstanding. etc.) are ideally suited to implement asset allocation decisions. plans are under way to introduce ETF’s that represent any actively traded portfolio of stocks. ETF’s that represent aggregated units of the market (sectors. or the Nasdaq-100. but provides the returns from owning a portfolio of stocks. QQQs are managed by the Bank of New York. 2000 publication by Lehman Brothers Equity Derivatives & Quantitative Research. called Standard and Poor’s Depository Receipts (SPDRs. the FTSE 100 etc. Energy.

5 . corporate actions. the fund manager can use futures contracts. equity index futures can play an important role for the index manager. For these managers. the futures contract was ideal for obtaining index exposure for extended periods of time. dividends. Then the asset manager can either roll into the next futures contract as time passes or let the position expire and invest in the actual stocks. cash management.1 . Figure 14 illustrates that the calendar spread trade has generally traded rich since 1995. however.Volatility Handbook changes.5 .0 0 . If the calendar spread is trading over the fair value the investor incurs roll cost.0 .3 .0 .5 Source: Lehman Brothers February 2002 29 . they have the ability to use other methods to obtain performance exposure to his or her benchmark. Namely. when the asset manager receives cash from dividends paid. redemptions and trading costs precipitate inefficiencies in this simple approach. the calendar spread can trade cheap which is a benefit.3 . many index managers are prohibited by the fund's bylaws from trading in derivative products. Figure 14: S&P 500 Calendar Spread 1988-2001 1 . For instance. If the calendar spread trades at fair value the roll cost is zero. Couple the cash management issues with changes in the benchmark from reconstitutions and M&A activity and things can get pretty complicated.5 1 . he should transform that cash position into index exposure. However. ETFs are a ”non-derivative” solution.5 0 .0 .2 .0 Aug-00 Aug-99 Aug-98 Aug-97 Aug-96 Aug-95 Aug-94 Aug-93 Aug-92 Aug-91 Aug-90 Aug-89 Aug-88 Aug-87 . exchange traded funds and options to make his job more efficient. Fortunately. Because of their lower transaction costs and minimal margin requirements. The job of managing an index portfolio becomes quite dynamic since he is receiving dividends with regularity and simultaneously managing cash inflows or outflows. for some index managers.0 . This cost is called the calendar spread and is measured as the annualized spread of the roll cost of closing the near futures contract and opening a position in the next futures contract versus the current risk free rate.2 .5 . An index manager that requires exposure to a benchmark index can make the appropriate investment in the futures contract. Historically. however more recent times have seen the cost of holding a futures position for an extended period of time become more costly.1 .

we assume a rate of 6 cents per share. The bid/ask spread also favors the futures contract. We use the lower of the two fees for our cost analysis. The figures used for both commissions and the bid/ask spreads are provided by Lehman Brother’s trading desk. The cost of holding a future for any length of time that requires the contract holder to enter into a calendar spread trade. or currently 4 basis points. or in terms of dollars. The ETF is a managed trust for which the investment advisor of the trust charges a fee. which currently amounts to 0. The unique cost to each product is where the separation occurs.5 index points. For our analysis we use a bid/ask spread of 0. The breakdown of the costs is as follows: ETFc = C + B/As + AF Fut c = C + B/As + R r Where: C = Commission cost (round trip or buy + sell) B/As = Impact cost reflected as the bid/ask spread AF = Advisor fee for the ETF Rr = Roll cost The costs that are common to both the ETF and the futures contract are commissions and the bid/ask spread. The S&P 500 exchange traded funds have the lowest fees of all existing ETFs. these costs are very different for each product. The advisor fee charged by the iShares S&P 500 index fund is 9 basis points. Commissions for the ETF are higher. Investors that were long June 2001 S&P 500 futures contracts and wanted to continue holding a long position in S&P 500 futures contracts had to roll into the September 2001 contracts by executing a calendar spread trade prior to the expiration of the June 2001 contract.4 basis points. distribution fees and other fees.Volatility Handbook Our analysis looks at the costs that an investor would incur for both products if the investor were to hold the investment for one year. 30 February 2002 . and the S&P 500 SPDR carries a fee of 12 basis points. or 8 basis points. The bid/ask spread for the ETF is 10 cents. The unique cost of the ETF is the advisor fee and the unique cost of the future is the roll cost. We use an estimate of $15 a contract. However. This fee is typically comprised of management fees.5 multiplied by $250 (or $125 per contract or 4 basis points). 0. It is well known that the commission cost associated with futures contracts are very low when compared to the notional size of a transaction. The roll cost is the premium an investor pays for selling the futures contract that is closest to maturity while simultaneously buying the futures contract with the next-closest maturity.

010 Source: Lehman Brothers Option Strategies for ETF Holders ETF investors can implement a variety of option-based strategies that can potentially enhance returns and lower risk on their ETF investment.545 or 27.416 yearly Roll Cost Total Cost for One Year Holding Period Total Cost/Notional 25 bps or $76. We use 100 futures contracts to establish the notional amount of this trade to be roughly $30 million. The common theme in the strategies is to provide the investor that has a directional view (bullish or bearish) with potentially yield enhancing strategies that can also lower the overall risk taken in the position. Additionally. and could even be negative under certain market conditions.462.5 * $250 * 100 contracts or 12. The roll cost of 25 basis points used in this analysis is the average daily roll cost in the four weeks leading up to contract expiration as measured in the last four quarters.156 yearly 94.500 Management Fees N/A .462.462.31% 0.22% Position Notional Amount ($) Cost Category Annual Commission . Here we present a few strategies that involve options and a position held in an ETF. OTC options might provide further flexibility and customization for investors over and above what is provided by the listed market. The comparison shows a dramatic difference in cost for a buy and hold investor. For investors that wish to implement an option strategy on ETFs that do not have listed options available. February 2002 31 .432 0.500 250. but some of the more liquid ETFs do have listed options. the roll cost is not a certain cost. Figure 16 is a table of ETFs trading in the United States that have listed option contracts.545 6 cents a share or $15.656 N/A 67. However. and tilts the scales in favor of the ETF.625 each $30. Listed options are not available for all available ETFs. Figure 15: One-Year Holding Period Costs of Futures versus ETFs S&P 500 Future S&P 500 ETF 100 Contracts @ $304. they can implement their strategy with OTC (over the counter) options.0009 * 30.103 $30.103 or 25.10 * 250.Volatility Handbook Figure 15 shows the scenario of an investor with a one-year holding period. The roll cost of the future dominates the analysis.000 .006 Bid/Ask Spread $15 a contract or $1500 * 4 or $6. The roll cost is a variable.

S. value managers in 1998 and 1999 and growth managers in 2000 were well positioned to undertake a call overwrite strategy. The writer of the option must satisfy the option holder by selling the ETF to the option holder at the designated strike price. For instance. the option writer will have the ETF called away" which means that the holder of the option is exercising his or her right to purchase the ETF at the designated strike price. can consider the call overwrite strategy to enhance yield on his/her investment. 32 February 2002 .809 Oil Services HOLDRs OIH 1. Hence. It is often a strategy employed by asset managers who are mandated to invest in a class of stocks that are neutral or under-performing.Volatility Handbook Figure 16: U. The investor collects the option premium of the written call option and maintains his/her long position if the option expires out of the money. a buy write strategy is not the strategy of choice if one is very bullish. but will underperform a simple long position if his ETF is called away.243 Semiconductor HOLDRs SMH 2.176 iShares S&P 100 Index Fund OEF 713 Pharmaceutical HOLDRs PPH 243 Internet HOLDRs HHH 238 Internet Architecture HOLDRs IAH 96 Telecommunications HOLDRs TTH 94 iShares Russell 2000 Index Fund IWM 88 Total Stock Market VIPERs Index Fund VTI 83 iShares Russell 2000 Growth Index Fund IWO 81 Wireless HOLDRs WMH 55 Internet Infrastructure HOLDRs IIH 42 Regional Bank HOLDRs RKH 27 Utilities HOLDRs UTH 24 Retail HOLDRs RTH 24 B2B Internet HOLDRs BHH 24 iShares Russell 1000 Index Fund IWB 20 Market 2000+ HOLDRs MKH 18 FORTUNE e-50 Index Fund FEF 10 Europe 2001 HOLDRs EKH 5 iShares Russell 2000 Value Index Fund IWN 3 Source: Lehman Brothers Call Overwrite Strategy An investor that currently holds a long position in a security and is neutral to moderately bullish.112 Biotech HOLDRs BBH 8. The investor will outperform the simple long position without call overwriting in all cases except where the underlying rises above the written call's strike price plus the collected premium at maturity. The investor who implemented the call overwrite strategy has a positive return for the period. ETF’s with Listed Options Fund Name Symbol Average Daily Option Volume Nasdaq-100 Index Tracking Stock QQQ 66. The strategy is designed to increase the investor's return if the long position is neutral over the period until the option's maturity. In this case.

Hence.July 1999 to July 2001 600% 140 120 100 80 60 40 20 0 400% 300% 200% 100% S hort Int erest Rat io Ju l-0 1 1 pr -0 01 A nJa O ct -0 0 0 l-0 Ju A pr -0 00 Ja n- 9 ct -9 O 0 0% 9 l-9 Ju 500% S hort Interes t Q Q Q S hort Int erest Source: Lehman Brothers February 2002 33 . Figure 18: QQQ Short Interest . we see their popularity as defensive hedges.Volatility Handbook Figure 17: Profit/Loss Diagram of Call Overwrite Strategy Profit & Loss Lon g Q s & W rite AT M C a lls 0% 15 0% 14 13 0% 12 0% 11 0% 10 % 90 % 80 % 70 % 60 % 50 0% Lon g Q s Equity P ric e Source: Lehman Brothers Put Overwrite Strategy A feature of exchange-traded funds is the ability to short on a down tick. ETF investors can quickly hedge certain market/sector exposures by entering into a short position in a declining market at a known price. Additionally. in a declining market. Upon examining short interest levels for SPDR’s and QQQs. market makers will often quote an ETF transaction as a principal trade.

July 1999 to July 2001 35 30 25 20 15 10 5 0 S ho rt Inte re s t 400% 300% 200% S h o rt In te re s t R a tio 1 Ju l. The only scenario in this strategy that will under-perform the simple short position is when the ETF price falls below the strike price of the written put option. but differs in one way: the investor is bearish and holds a short position in the ETF (the underlying). Figure 20: Profit/Loss Diagram of Put Overwrite Strategy Profit & Loss S h ort Q s & W rite O u t-of-Mon e y P u ts Equity P ric e Source: Lehman Brothers 34 February 2002 0% 12 0% 11 0% 10 % 90 80 % S h ort Q s .0 Ju 0 pr -0 A 00 n- Ja O ct -9 9 9 100% 0% l. The investor writes put options against the ETF short position and expects to collect the premium if the ETF price is above the written puts strike price when the option expires. less the collected premium.9 Ju 600% 500% S P Y S h o rt In te re s t Source: Lehman Brothers The put overwrite strategy is very similar to the call overwrite strategy. Figure 20 illustrates the profit and loss scenario at expiration.Volatility Handbook Figure 19: SPYs Short Interest . the put overwrite strategy will outperform a simple short position. Otherwise.0 1 pr -0 01 A nJa -0 0 0 ct O l.

ETF’s are a cost-efficient way to implement strategies or views at the sector level. Prior to the creation of ETF’s.Volatility Handbook Conclusion Presuming returns can be forecast. investment managers had to trade in portfolios of securities to gain exposure to the relevant size. The impending introduction of ETF’s in the world of actively managed funds (and hedge funds) can only increase their acceptance and broad appeal as an instrument of asset allocation strategies. February 2002 35 . we believe ETF’s are likely to show increasing acceptance globally in the near future. We also presented a list of potential investment strategies for which the ETF’s would prove to be ideal instrument of execution. transparency in pricing and liquidity. breadth of asset class coverage. Below we provide lists of index ETF’s available by asset class. We highlighted the major benefits of ETF’s: lower transaction costs. For these reasons. sector and geographic region. This caused higher transaction cost—both in trading and management of those portfolios—in the implementation of active asset allocation strategies. style or sectors.

25% iShares Russell 2000 Value 0.253 5/26/00 0.023 7/28/00 0.70 43.15 11 0.56% 520.45% 7.20% iShares Russell 2000 Growth 0.25 18.09% Diamonds Trust Series I 13.464.98% IWM IJR IWV IYY S&P 400 Mid-Cap Dep Recpt 27.50 44.95 12.25% iShares Russell 3000 Growth 0.20% IWF iShares Russell 1000 Growth IWD IWO IWN IWZ IWW 0.068 5/4/95 0.82% 1.95 1.375 5/26/00 0.44% 1.446 7/28/00 0.25% iShares S&P SmallCap 600/Barra Value 0.596.25% iShares S&P SmallCap 600/Barra Growth 0.99 0.789 6/16/00 0.32 0.75 1.662 5/26/00 0.20% iShares Total Market 0.677 2.40 44 0.20 14.30 247 0.733.25% 5/26/00 0.457 7/28/00 0.892 7/28/00 0.339.704 0.35 29.84 0.37 0.20% iShares Russell 2000 2.Volatility Handbook List of Available ETF’s on Selected Indices Figure 21: List of Currently Available ETF’s Related to Style (Growth/Value) Asset Class Ticker Name Avg Outstanding Assets (m) Bid/Ask Shares (m) Spread Average Dollar Volume Inception Date IVW iShares S&P 500/Barra Growth 0.957 QQQ MDY IVV DIA IWB IJH Nasdaq-100 Shares 128. Additionally.25% Source: Bloomberg Note: Average Bid/Ask Spread and average dollar volume is calculated over the last 30 days.788 0.18% IJK IJJ IJT iShares S&P Midcap 400/Barra Growth 0.443 7/28/00 0.644.40 33 0.50% Advisor Fee IVE iShares S&P 500/Barra Value 0.85 1.18% 55.20% Source: Bloomberg Note: Average Bid/Ask Spread and average dollar volume is calculated for the last 30 days.534 0.952 1/29/93 0.20% iShares Russell 3000 0.92 17.68% 256. 36 February 2002 .53% 1.25% Ticker Name SPY S&P 500 Depositary Receipt 118. outliers are eliminated from the average calculation.067.657 iShares Russell 1000 Value 0.30 0.688 1/20/98 0.72 0.58% 28.65% 302.25 238 0.71 0.526 7/28/00 0. outliers are eliminated from the average calculation.872 5/19/00 0.25 17.25% iShares Russell 3000 Value 0.258 8/4/00 0.25 19.40% 269.18% iShares Trust .246.83% 1.404 5/26/00 0.456 3/10/99 0.35 0.68% 22.81% 3.58% 762.628.51% 9.981.35 37.368.934.20% iShares S&P SmallCap 600 0.25 36.67% 737. All funds mentioned above are managed by Barclays Global Advisors Ltd.989.74% 1. All funds mentioned above are managed by Barclays Global Advisors Ltd. Figure 22: Currently available ETF’s related to size (large/medium/small) asset class Avg Outstanding Assets (m) Bid/Ask Shares (m) Spread Average Dollar Dollar Volume Inception Date 0.18% 75.45 25.961 5/26/00 0.54 0.44 0.25% 86.25% IJS iShares S&P Midcap 400/Barra Value 0.290 5/26/00 0.165.Russell 1000 3.12% 0.68% 109.30% 37.59% 588.743 5/19/00 0. Additionally.296.12 0.616 7/28/00 0.15% iShares S&P Midcap 400 2.77 0.40 274 0.797 5/26/00 0.50% 660.20 17.46 Advisor Fee iShares Trust -S&P 500 11.

336 612.05 5.64% 1.71% 1.43 3.46% 1.35% 1.28% 0.28% 0.044 6.28% 0.60% 0.84 2.60% 0.40 0.97% 0.40 2.594 8. With respect to the aggregate custody fee payable in any calendar year.775 1.920 1.542 52.41% 1.064.25 112.87% 0.85% 1.079.971 * 0.326 1.48% 2.551.18% 0.07% 1.920.60% Biotech Holdrs Trust Technology Select Sector Internet Holdrs Trust B2B Internet Holdrs Trust Pharmaceutical Holdrs Trust Broadband Holdrs Trust Telecom Holdrs Trust Amex Financial Select Spdr Internet Infrastructure Hold Internet Architect Holdrs Tr Amex Energy Select Spdr Amex Consumer Staples Spdr Semiconductor Holdrs Trust iShares Trust-Dow Jones Tech Amex Basic Industries Spdr iShares Dow Jones Financial Amex Cycl/Trans Select Spdr Utilities Select Sector Indx Regional Bank Holders Trust Amex Industrial Select Spdr Amex Consumer Svc Select Spd iShares Trust -Dow Jones Int iShares Trust US Financial Services Utilities Holders Trust iShares Dow Jones Telecomm Sector iShares Dow Jones Energy Sector iShares Dow Jones Utilities iShares Dow Jones Industrials iShares Dow Jones Healthcare iShares Dow Jones Real Estate iShares Dow Jones Chemicals iShares Dow Jones Consumer Cyclicals iShares Dow Jones Consumer Non Cyc iShares Basic Materials 2.60% 0.938.67% 1.298 3.77 6.425 876 735 590 568 514 457 438 343 319 250 206 140 113 111 103 88 87 86 82 81 66 60 37 32 32 29 25 22 17 15 12 9 1.223.28% * 0.117.70 0.Volatility Handbook Figure 23: Currently Available ETF’s Related to Industry Sectors Ticker Name Avg Outstanding Assets (m) Bid/Ask Shares (m) Spread Average Dollar Inception Date FUND ADVISOR Volume Advisor Fee BBH XLK HHH BHH PPH BDH TTH XLF IIH IAH XLE XLP SMH IYW XLB IYF XLY XLU RKH XLI XLV IYV IYG UTH IYZ IYE IDU IYJ IYH IYR IYD IYC IYK IYM 10.19% 0.63% 0.868 1. Additionally.58 0.837 1.338 8.28% 0.62% 0.05 0.272 6.403 5.60% 0.40 0.79% 1.30 0.28% * * * * * 0.28% * 0.575 211.264 363.982 258.043.72% 0.60% 0.35 7.984 11.772 11.53% 1.60% * 0.812.01% 1.10 0.60% 0.03 7.862.05 3.136.91% 0. February 2002 37 .807 507. Note: Expenses for HOLDRS: The Bank of New York as trustee and custodian for the HOLDRS may charge a custody fee of $2 per round lot per quarter.72% 0.30 9.345 51.25 0.70 1.052 8.489 998.60% 0.966 2.52% 1.823 5.24% 0.60% 0.302.65 1.28% * * 0.83 16.30 0.60 0.03% 1.40% 1.079.39% 0.45 0.652 991.183.377 4.60% 0.61 14.733 1.81% 11/23/99 12/31/98 9/23/99 2/24/00 2/1/00 4/6/00 2/1/00 12/22/98 2/25/00 2/25/00 12/22/98 12/22/98 5/5/00 5/19/00 12/22/98 5/31/00 12/22/98 12/22/98 6/23/00 12/22/98 12/22/98 5/19/00 6/21/00 6/23/00 5/26/00 6/16/00 6/20/00 7/14/00 6/16/00 6/19/00 7/28/00 6/28/00 6/16/00 6/20/00 Merrill Lynch State Street Global Advisors Merrill Lynch Merrill Lynch Merrill Lynch Merrill Lynch Merrill Lynch State Street Global Advisors Merrill Lynch Merrill Lynch State Street Global Advisors State Street Global Advisors Merrill Lynch Barclays Global Advisors State Street Global Advisors Barclays Global Advisors State Street Global Advisors State Street Global Advisors Merrill Lynch State Street Global Advisors State Street Global Advisors Barclays Global Advisors Barclays Global Advisors Merrill Lynch Barclays Global Advisors Barclays Global Advisors Barclays Global Advisors Barclays Global Advisors Barclays Global Advisors Barclays Global Advisors Barclays Global Advisors Barclays Global Advisors Barclays Global Advisors Barclays Global Advisors Source: Bloomberg Note: Average Bid/Ask Spread and average dollar volume is calculated for the last 30 days.60% 0.45 0.62% 1.54% 0.70 0.388.120.282.75 2. the trustee will waive that portion of the fee which exceeds the total cash dividends and other cash distributions received.634.709.004 1.833 8.28% 0.547 7.14 1.27 6.99% 0.87% 0.014 85.60% 1.60% 0.60% 0.940 17. outliers are eliminated from the average calculation.56% 1.35 4.261.70 7.80 10.80% 1.491 788.700 3.38 25.836.

83% 207.82% 228.29% 228.74% 518.88 45 2.099.84% EWP iShares MSCI Spain Index 1.40 11 5.85% 355.84% 1.664 3/18/96 Barclays Global Advisors 0.84% EWS iShares MSCI Singapore Free 11.20 158 0.10 18 2.150 3/18/96 Barclays Global Advisors 0.669 3/18/96 Barclays Global Advisors 0.84% EWK iShares MSCI Belgium Index 1.48% 108.087 7/28/00 Barclays Global Advisors 0.08% 640.65 40 1.84% EWQ iShares MSCI France Index 3.11% 873.639 3/18/96 Barclays Global Advisors 0.01% 202.278 3/18/96 Barclays Global Advisors 0.816 3/18/96 Barclays Global Advisors 0.84% EWY iShares Korea Webs Index 0.84% 0.302.98 23 1.30 31 2.722 3/18/96 Barclays Global Advisors 0.73 100 5.40 39 2.51% 390. Additionally.61% 1.42% 711.84% EWL iShares MSCI Switzerland 2.372.791 3/18/96 Barclays Global Advisors 0.75 15 1.10 49 0.84% EWD iShares MSCI Sweden Index 0.067.50% EWJ iShares MSCI Japan Index 57.84% 0.80 144 2.25 50 1.60 96 1.324 4/11/00 Merrill Lynch 0.20 16 0.788 3/18/96 Barclays Global Advisors 0.518 3/18/96 Barclays Global Advisors 0.432 7/31/00 Barclays Global Advisors 0.03% 207.84% EWW iShares Mexico Index Series 2.76% 523.112 3/18/96 Barclays Global Advisors 0.126 4/28/00 Barclays Global Advisors EWG iShares MSCI Germany Index 7.000 3/18/96 Barclays Global Advisors 0.84% EWI iShares MSCI Italy Index 2.283 5/12/00 Barclays Global Advisors 0.84% EWA iShares MSCI Australia Index 6.864 3/18/96 Barclays Global Advisors EWN iShares MSCI Netherlands 1.40% ISF ln iShares FTSE 100 10.600 3/18/96 Barclays Global Advisors 0.634 3/18/96 Barclays Global Advisors 0.512.00 787 2.00 80 3.00 13 3.37% 143.445 3/18/96 Barclays Global Advisors 0.84% EWC iShares MSCI Canada Index 1.50% 4.20 62 4.Volatility Handbook Figure 24: List of Currently Available ETF’s Related to Country or Global Region Ticker Name Avg Average Outstanding Assets (m) Bid/Ask Dollar Shares (m) Spread Volume Inception Date Fund Advisor Advisor Advisor Fee IEV iShares Trust -S&P Eur 350 0. outliers are eliminated from the average calculation 38 February 2002 .065 4/11/00 Merrill Lynch 0.731 3/18/96 Barclays Global Advisors 0.84% EWM iShares MSCI Malaysia (Free) 16.72% 562.59% 1.84% EWO iShares MSCI Austria Index 1.84% EUN2 Dow Jones Euro Stoxx 50 7.00 324 0.50% EUN1 Dow Jones Stoxx 50 Fund 1.84% EWU iShares MSCI United Kingdom 7.84% Source: Bloomberg Note: Average Bid/Ask Spread and average dollar volume is calculated for the last 30 days.50 154 1.46% 276.70 90 4.84% EWH iShares MSCI Hong Kong Index 6.62% 1.60% EZU iShares Trust -EMU Index Fd 0.55 42 0.58% 693.60% 66.

which is a function of liquidity and demand. European style expiration. the number of option contracts an investor would buy depends on the value of the underlying asset. these American Stock Exchange (AMEX) traded options have the narrowest bid-ask spread of any option studied as well as the convenience of physical settlement (upon which the underlying QQQ shares are delivered instead of cash). is a prime example of the vast potential for synthetic index products that appeal to a larger pool of investors. Launched in March 1999. Here. and commission paid to determine the most cost-effective option. settlement style and daily trading volume. transaction costs of executing a trade. Given a desired dollar amount of Nasdaq exposure. Derivative markets around QQQ’s also experience heavy trading volume. We examine total transaction cost per contract as a function of bid-ask spread. an exact replication of the NASDAQ-100 that is based on 1/10th of its value. the QQQ is a security whose value approximates 1/40th the value of the underlying Nasdaq-100 index and is one of the most liquid products traded in the market today. we compare Nasdaq-100 synthetic derivative products across several criteria to determine the relative efficiency with which each product meets different investment goals. transaction costs can be a big factor in choosing the right investment vehicle. we compare March 2002 options on the NDX. We compare and contrast the costs involved in trading three basic option products that replicate the Nasdaq-100: NDX options.Volatility Handbook Cost-Effective Trading: A Look at Nasdaq-100 Derivative Products The popularity of the index marketplace has spurred the development of innovative new derivatives products that offer investors more freedom to tailor their exposure than ever before. but still remain one of many options for an investor seeking Nasdaq exposure. As Figure 22 shows. $25 strike price intervals and a comparatively large bid-ask spread (averaging 80 basis points wide daily in 2001 compared to 29 basis points average for the QQQ March 40 Call).or short-term expirations. frequency of expiration. Below. NDX Call: NDX options have a high premium. NDX options are also traded February 2002 39 . The Nasdaq-100 Index Tracking Stock (or QQQ). which are all potentially limiting factors for investors. We provide a brief description and characterize NDX derivative products by considering differences in bid-ask spread. QQQ options are American style and therefore can be exercised early. With an increased number of products offering synthetic index exposure. We also consider derivative products of the Mini-NDX (called the MNX). Mini-NDX Options and QQQ options. QQQ and MNX. an exchange-traded fund that had an average trading volume of 70 million shares a day in 2001. Description of Option Products QQQ Call: Available in $1 strike price intervals and long.

000.000 25. the QQQ Call costs less than half the amount required to trade NDX or MNX options. and typically have a bid-ask spread slightly higher than that of the NDX option. As Figure 25 shows. which gives an investor the option to roll over exposure instead of cashing out upon expiration. 23 Trading hours for options on the CBOE are 8:30 a. The total cost is broken down into two segments: bid-ask spread per contract purchased. and the fixed cost of brokerage commission. Even after factoring in a $3 commission per contract. have trading hours of 9:30 a.000 25. Bloomberg. we compare the total cost of trading each option contract using indicative prices as of January 2. CBOE Transaction Cost Analysis Assuming a portfolio size of $30 million and a commission of $3. 24 Average spread is calculated from daily closing bid and ask prices in 2001. with no more than 15. QQQ options offer smaller trading increments. 10 MNX options are equivalent to one fullvalue NDX option.m. 25 The combined NDX and MNX option position limit is 25. to 4:15 p. Chicago time (one hour behind Eastern Std Time). Figure 25: Comparison of NDX Options QQQ Option NDX Option MNX Option Number of Expirations Nearest three months plus Mar-JunSep-Dec qtrly cycle Nearest three months plus Mar-Jun-Sep-Dec qtrly cycle Nearest three months plus Mar-Jun-Sep-Dec qtrly cycle Exercise Type American European European Exchange AMEX CBOE CBOE 86 2001 Average Daily BidBidAsk Spread (bps)24 29 80 Position Limit (# of contracts) 25 150.03 per share. . The total cost of trading a $30 million notional amount of QQQ options is slightly more than $88. equivalent to $0.000 contracts on the same side of the market. Exemptions may be obtained for certain public customers and proprietary accounts of member organizations. almost 1/3 the cost of trading an equivalent notional value of the NDX or MNX options. For less than half the transaction cost. since its narrow bid-ask spread more than compensates for the greater commission paid. 23 MNX Call MNX options are offered on the CBOE. 26 40 February 2002 For NDX options.Volatility Handbook on the Chicago Board Options Exchange (CBOE).000 Strike Price Intervals26 $1 $50 $5 Source: Lehman Brothers. have $5 strike price intervals. a variable cost that accounts for option liquidity and market value per contract. The position limit for QQQ options will be reduced to 75.000 in February 2002.m. EST. the QQQ option has the lowest total cost of trading. which trade on the AMEX. 2002. QQQ Options.m. Spread is shown in basis points as a fraction of the ATM strike price. the two nearest expirations have trading increments of $25 and all others are $50.00 per contract.000 contracts in the near-term series. greater liquidity and physical delivery. to 3:15 p. which follows slightly different market hours than the AMEX and other exchanges.m.

152 $5.000.500 $110. of contracts needed for $30 million notional exposure BidBid.712 $563 $241.Volatility Handbook In Figure 26 below.214 $22.625 $264. February 2002 41 . We examine the March 2002 option for each series.50 $11350 188 $240.275 80 MNX Mar 160 Call $10. The strike prices and premiums listed are not current and used for indicative purposes only.Ask Spread Cost Commission Total Cost Total Cost on Notional Amt ( in bps)27 QQQ Mar 40 Call $3 $300 7500 $88.81 $1081 1875 $259. we use actual option contracts on the NDX.777 88 Source: Lehman Brothers.000.714 37 NDX Mar 1660 Call $113. Figure 26: Transaction Cost Comparison Option Option Premium Mkt Value of one Contract No. MNX and QQQ to compare the transaction costs associated with a hypothetical trade. Bloomberg 27 Shows the total transaction cost as a fraction of the notional amount purchased. in this case. the hypothetical amount chosen is $30.

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Volatility Handbook Section 4: Derivatives Trading Regulation and Market Structure February 2002 43 .

CBOE Automatic Exercise of Options at Expiration A listed option’s settlement procedure is determined by the Option Clearing Corporation (OCC).m. the previous closing price in the primary market will be used to determine the settlement price for that day. Eastern Standard on the last business day prior to expiration. For equity options. There is no margin by which the underlying must exceed the strike for cash settled options. must submit “Contrary Exercise Advice” no later than 5:30 p. If the closing price is less than ¾ point above the strike for individual investors or ¼ point for market makers. Figure 27 provides the various month codes for futures and listed options. unless there is a holiday on the Friday. Exercise will occur automatically if the closing price of the security exceeds the strike price by ¾ point for individual investors and ¼ point for market makers or firms. This number represents the year of expiration. Investors who want to exercise an OTM option. the holder can choose whether or not to accept delivery. The option will expire worthless if the holder rejects delivery. Figure 27: Month Codes for Futures and Options Month Futures Code March H June M September U December Z Month Jan F eb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Calls A B C D E F G H I J K L Puts M N O P Q R S T U V W X Source: Bloomberg. or choose not to exercise an ITM option. Options that are physically settled involve the delivery of the underlying stock. cash settled options will be automatically exercised if they are in the money at expiration. Expiration officially occurs on the Saturday after the third Friday of the month.Volatility Handbook Market and Exchange Details Futures and listed options quotes are constructed with the last letter of the ticker symbol representing the month that the contract will expire. Often a number will follow the month letter. Final Settlement Value at Expiration The settlement value at expiration for index options and futures is determined by the opening prices on expiration day of the index constituents for most contracts. If a constituent stock does not open for a day. 44 February 2002 . hence. the expiration settlement value is determined using the closing price on expiration day.

UTY: Philadelphia Utility Index February 2002 45 .g. For example. September and December). XCI. Adjustments to option contracts are most commonly made as a result of mergers. 2:1. the owner of one option with a strike price of 100 on a stock that splits three-to-two will now have a contract that represents 150 shares with a strike price of 66. Some sector options also use the closing rather than opening price including. adjustments are only made when the underlying security issues a special stock dividend. OEX options expire using the last reported sales price in the primary market of each component stock on the last business day before the expiration date (usually expiration week Friday’s close) or on the day the exercise notice is properly submitted if exercised before expiration. 3:2. If the underlying stock split results in fractional contracts (e. acquisitions or stock splits. XAU and UTY. 10:1).g. Changes usually take place on the “ex-date” established by underlying security’s market. 4:5. the strike prices of existing option contracts are adjusted proportionally. Section 11 of the OCC Rule Book. The four new option contracts leave the investor in the same position as the single initial option contract. In the case of dividends and distributions. The official adjustment guidelines are documented in Article VI. For all other months.. Fractional contracts are rounded to the next whole number. but the final adjustment decision for existing option contracts is made at the complete discretion of the Securities Committee. For example. 4:1. 7:8). a subcommittee of the OCC. 28 Corporate Action Adjustments The Options Clearing Corporation determines most equity option adjustments in the United States. Otherwise. regardless of the exchange they trade on. XOI: AMEX Oil Index. The general rule for stock splits is that any time the split is expressed as a ratio to 1 (e. additional contracts are created and the strike price is reduced accordingly. defined as greater than 10% of the market capitalization on the close of trading on the declaration date. June. the owner of one option with a strike price of 80 on a stock that splits four-to-one will now own four options that each have a strike price of 20. XOI..Volatility Handbook The settlement value for options on futures at expiration is based on the opening prices for the quarterly expirations (March. XAU: Philadelphia Gold and Silver Index. The National Over-the-Counter (OTC) Index options use the closing prices of the last trading day before expiration as a settlement price(usually the expiration week’s Friday close). the settlement value is determined as of the closing price. then the strike price is reduced and the number of shares that each contract represents increases proportionally. no adjustments are 28 XCI: AMEX Computer Technology Index.

all outstanding contracts are adjusted to require the delivery of the newly formed entity. Details of Listed Futures Contracts In Figure 28. Upon completion of a corporate action resulting in a new corporate entity.Volatility Handbook made to outstanding option contracts. indices 46 February 2002 . but all interest and dividends attributable to the underlying security becomes payable in the form of additional units per contract. we provide contract and exchange details for futures available on U. the transaction is handled on a case-by-case basis due to the numerous possible distributions that could take place. The underlying securities of an ITM option will be converted into rights to receive a fixed amount of cash and all OTM and ATM options become immediately worthless. Changes in capital structure do not affect options. the option parameters do not change. In case of a property dividend issuance.S. Tender offers and poison pills do not alter option contracts. If a security can be converted into a debt instrument or preferred security.

Dec ND__ / ND__ Sec: 16500 Speculator Ini: 15000 Sec: 12000 Hedger Ini: 12000 Same as S&P 500 Same as S&P 500 Same as S&P 500 250 0.05 Mar. Jun. Jun. Jun.10 Mar. Mar. Sep. Jun.DJI) ND__ / ND__ Sec: 10000 Hedger RL__ / RL__ S&P/BARRA Value (IVX / . Sep. Sep. Dec ND__ / ND__ Sec: 11500 Speculator Ini: 22275 Sec: 16500 Hedger Ini: 16500 S&P/BARRA Growth Same as S&P 500 Same as S&P 500 (IGX / . 10%.05 Mar. Dec Sec: 10000 Sec: 9600 Sec: 9600 Speculator Ini: 15525 Sec: 11500 Hedger Ini: 11500 NASDAQ Same as S&P 500 Same as S&P 500 100 9:30 – 16:00 0. Same as S&P 500 Same as S&P 500 Same as S&P 500 50 Margin Limits 0. CME stock index futures and options will close at 3:05 PM (Chicago time) on such days.25 Mar. All domestic stock index futures and options. settlement prices are based on sampling the 3:05 PM (Chicago time) cash index values. Nasdaq-100. Please note that regular settlement procedures will be observed on all other trading days apart from the last business day of each calendar quarter. Sep. including the S&P 500. Sep.SKX) Same as S&P 500 250 0. Indices Index Name Allowable Maximum (Bloomberg/Reuters Stock Exchange(s) Futures Exchange and Trading Trading and Trading Futures Daily Price Codes) Hours Hours Movements Futures Codes) S&P 500 (SPX / . Jun. Sep. NASDAQ.100 (NDX / . S&P?BARRA Growth and Value Indices.05 Mar. Dec Speculator Ini: 4688 Same as S&P 500 Same as S&P 500 Same as S&P 500 500 0.Cap 400 (MID / .10 Mar. 15% and 20% 17:30 – 8:15 on Sun. Dec ND__ / ND__ Sec: 12000 Speculator Ini: 8348 Sec: 6750 Hedger Ini: 6750 DJIA (INDU / .00 Mar.SZX) Sec: 3750 Speculator Ini: 9600 NasdaqNasdaq. E-Mini S&P 500.RUT) Sec: 4000 Hedger ES__ / ES__ S&P MidMid.On the last business day of each calendar quarter.RUI) Sec: 4000 Hedger MD__ / MD__ Russell 1000 (RTY / . Dec Ini: 5000 Ini: 4000 0. CME Regular Session AMEX hours are 8:30 – 15:15* 9:30 to 16:00 GLOBEX The absolute price limits 250 are set on a quarterly basis and are based on percentages of 2.NDX) Sec: 3750 Hedger Ini: 10000 Russell 2000 (RIY / . S&P Mid-cap 400. Jun and Sept. Jun. holidays of the average closing price of the lead month futures contract in Dec. Dec RD__ / RD__ Ini: 9600 Same as S&P 500 Same as S&P 500 Same as S&P 500 500 0. Dec Ini: 3750 Speculator Ini: 13500 Same as S&P 500 Same as S&P 500 Same as S&P 500 500 0. Jun.MID) Speculator NYSE Chicago Board of Trade (CBOT) Same as S&P 500 9:30 – 16:00 7:20 – 15:15 10 1. E-Mini Nasdaq-100 and Russell 2000 Markets. Sep. Jun. Dec Sec: 6750 Speculator Ini: 6000 Sec: 5000 Hedger Ini: 5000 Sec: 5000 Source: Bloomberg * . February 2002 47 .10 Mar. Sep.5%.Volatility Handbook Figure 28: Details of Futures Contracts Available on U. 15:45 – 8:15 on Mon-Thu 5%.S.SPC) SP__ / SP__ S&P 500 (Min) (SPX / .SPC) Contract Tick Contract Multiplier Size Months NYSE.05 Mar. Sep. Jun.

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or other factors.20. may from time to time have long or short positions in such securities or in options. NY 10019 USA 1.. Lehman Brothers may have managed or co-managed a public offering of securities for any issuer mentioned in this document within the last three years. perform investment banking or other services for. futures. member SIPC. officers. All rights reserved.4275 Tokyo 12-32 Akasaka 1-chome Minato-ku Tokyo 107 Japan 813.5571. Singapore Branch. Opinions expressed herein reflect the opinion of Lehman Brothers and are subject to change without notice. regulated by the Securities and Futures Authority. The value and the income produced by products may fluctuate. and in Hong Kong by Lehman Brothers Asia Limited. Lehman Brothers may make a market or deal as principal in the securities mentioned in this document or in options. or solicit investment banking or other business from any company mentioned in this document. Additional information is available on request. Past performance is not necessarily indicative of future results.3000 This material has been prepared and/or issued by Lehman Brothers Inc. is accurate or complete and it should not be relied upon as such. its shareholders. he should consult his Lehman Brothers representative. including any third-party information. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers. or may. and they may not be suitable for all types of investors.. We do not represent that this information. Ó 2002 Lehman Brothers. The products mentioned in this document may not be eligible for sale in some states or countries. It is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity. This material is distributed in Australia by Lehman Brothers Australia Pty Limited. This material is distributed in Japan by Lehman Brothers Japan Inc. One or more directors.. in connection with its distribution in the European Economic Area. or other derivatives based thereon.7000 London One Broadgate London EC2M 7HA England 44. from time to time. so that an investor may get back less than he invested.526. and in Singapore by Lehman Brothers Inc. Lehman Brothers. In addition.7256. part of the capital invested may be used to pay that income. futures. and/or employees of Lehman Brothers may be a director of the issuer of the securities mentioned in this document. Please contact a Lehman Brothers entity in your home jurisdiction. directors. officers and/or employees. Value and income may be adversely affected by exchange rates.2869.7357 Hong Kong One Pacific Place 88 Queensway. If a product is income-producing. interest rates.212. or other derivative instruments based thereon. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it.GLOBAL EQUITY DERIVATIVES New York 745 Seventh Avenue New York. Hong Kong 852. If an investor has any doubts about product suitability. US02-0495 . and/or one of its affiliates (“Lehman Brothers”) and has been approved by Lehman Brothers International (Europe).