Sheldon Natenber: OPTION VOLATILITY PRICING eM Tiere Meee) Strategies and Techniques McGraw-Hill New York San Francisco Washington, D.C. Auckland Bogoté Caracas Lisbon London Madrid Mexico City Milan Montreal New Delhi San Juan Singapore Sydney Tokyo Toronto© 1994, Richard D. Irwin, a Times Mirror Higher Education Group, Inc. company ALL RIGHTS RESERVED. No part of this publication may be reproduced, stored ina retrieval system, or transmitted, in any form or by any means, elec- tronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher and the authors. This publication is designed to provide accurate and authoritative information in regardto the subject matter covered. It is sold with the understanding that the author and the publisher are not engaged in rendering legal, accounting, or other professional advice. ISBN 1-55738-486-X Printed in the United States of America BB 22 21 20 19 18 17 CB/TAQ/BIS McGraw-Hill se ‘ADs of The McGraw Fl ComparesTo Paul, for convincing me to become an options trader; To Hen and Jerry, for their financial help when | needed it; To Eddie, who encouraged me to finish the book and get off the computer so he could do his homework; And most of all to Leona, for her support and encouragement.Table of Contents < Preface to the First Edition Preface to the Second Edition e1e The Language of Options Contract Specifications Exercise and Assignment Market Integrity Margin Requirements Settlement Procedures ele Elementary Strategies Simple Buy and Sell Strategies Risk/Reward Characteristics Combination Strategies Constructing an Expiration Graph +34 Introduction to Theoretical Pricing Models Expected Return Theoretical Value A Word on Models A Simple Approach Exercise Price Time to Expiration Price of the Underlying Interest Rates Dividends Volatility Bn Soonee 13 13 16 19 23 35 36 37 39 46 47 47 48 40vi Table of Contents 51 Random Walks and Normal Distributions 31 Mean and Standard Deviation 56 Underlying Price as the Mean of a Distribution 60 Volatility as a Standard Deviation 60 Lognormal Distributions 61 Daily and Weekly Standard Deviations 65 Volatility and Observed Price Changes 07 ANote on Interest Rate Products 68 ‘Types af Volatilities 69 o5% Using an Option’s Theoretical Value 81 o6% Option Values and Changing Market Conditions 95 ‘The Delta 99 The Gamma 103 The Theta 11 The Vega or Kappa 113 The Rho 116 Summary 118 e7% Introduction to Spreading 127 What Is a Spread? 127 Why Spread? 132 Spreading as a Risk Management Tool 133 obo Volatility Spreads 137 Backspread (also referred to as a ratio backspreador long ratio spread) 138 Ratio Vertical Spread (also referred to as a ratio spread, short ratio spread, vertical spread, or front spread) 139 Straddie 141 Strangle 143Table of Contents Butterfly Time Spread (also referred to as a calendar spreador horizontal spread) The Effect of Changing Interest Rates and Dividends Diagonal Spreads Other Variations Spread Sensitivities Choosing an Appropriate Strategy Adjustments Entering a Spread Order Oe Risk Considerations Choosing the Best Spread Practical Considerations How Much Margin for Error? Dividends and Interest What Is a Good Spread? Adjustments A Question of Style Liquidity #10% Bull and Bear Spreads Naked Positions Bull and Bear Ratio Spreads Bull and Bear Butterflies and Time Spreads Vertical Spreads ee Option Arbitrage Synthetic Positions Conversions and Reversals Arbitrage Risk Boxes Telly Rolls Using Synthetics in Volatility Spreads Trading without Theoretical Values vit 145, 154 157 157 159 161 168 169 173 173 181 187 188 192, 193 195 196 199 199 199 201 202 213 213 27 223 228 231 233 235vet o12¢ Early Exercise of American Options Futures Options Stock Opuons The Effect of Early Exercise on Trading Strategies 13% Hedging with Options Protective Calls and Puts Covered Writes Fences Complex Hedging Strategies Portfolio Insurance elas Volatility Revisited Some Volatility Characteristics Volatility Forecasting A Practical Approach Some Thoughts on Implied Volatility e154 Stock Index Futures and Options What Is an Index? Calculating an Index Replicating an Index Stock Index Futures Index Arbitrage Index Options Biases in the Index Market e1l6e Intermarket Spreading An Intermarket Hedge Volatility Relationships Intermarket Volatility Spreads Options on Spreads Table of Contents 241 241 243 250 257 258 260 263 265 268 273 273 279 282 290 301 301 302 304 305 309 313 326 331 335 336 339 351able of Contents e17% Position Analysis Some Simple Examples Graphing a Position ‘A Complex Position Futures Option Positions +184 Models and the Real World Markets Are Frictionless Interest Rates Are Constant over the Life of an Option Volatility Is Constant over the Life of the Option Trading Is Continuous Volatility Is Independent of the Price of the Underlying Contract Over small periods of time the percent price changes in an underlying contract are normally distributed, resulting in a lognormal distribution of underlying prices at expiration Skewness and Kurtosis Volatility Skews A Final Thought + Appendix A + A Glossary of Option and Related Terminology > Appendix B + The Mathematics of Option Pricing Option Pricing Models Normal Distributions Volatility Calculations The Extreme Value Method ‘The Exponential and Natural Logarithm Functions Appendix C + Characteristics of Volatility Spreads Appendix D + What's the Right Strategy? 353 353 358 367 372 385 386 388 390 394 399 400 402 405 416 419 431 431 439 442 443 446 449 451x Table of Contents * Appendix E + Synthetic and Arbitrage Relationships 453 Arbitrage Values for European Options (no early exercise permitted) 455 Other Useful Relationships: 456 © Appendix F & Recommended Reading 457 Elementary Books 457 Intermediate Books 459 Advanced Books 461 + Index + 463«+ Preface to the First Edition < Within the last decade trading options has increased at an explosive rate. Not only have traditional market participants, speculators, hedgers, and arbitrageurs all become ac- tively involved in option markets, but the number of individual floor traders willing to risk their own capital in these markets has grown dramatically. Yet the trader entering an option market for the first time may find that his initial efforts are less than totally successful. Indeed, the learning period in options during which a trader gains full confidence in his ability to survive and thrive under all types of market conditions may require many months or even years of trading experience. Unfortunately, the great majority of traders do not survive this learning period. The usual characteristics of options, the subleties of the marketplace, and the unforseen risks, all seem to conspire against the inexperienced trader and eventually lead to his demise. Much of the pain experienced by a new trader could be avoided if the trader were better prepared for the realities of option trading. Unfortunately, existing option litera- ture has tended to take either a highly theoretical approach best suited to an academic environment, or a simplistic approach presenting options as just another way of trading stocks or commodities. Neither approach is likely to meet the needs of the serious trader. The former approach is not only mathematically beyond the capabilities of most traders, but relies heavily on theoretical assumptions which are too often violated in the real world. The latter approach cannot possibly prepare a serious trader for the wide variety of strategies with which he must be familiar, nor with the very real risks to which he will be exposed. This book was written with the hope of filling the void in the traditional option literature by combining theory and real-world practice. Moreover, it was written Primarily with the serious trader in mind. This includes traders whose firms are actively Involved in option markets, either by choice or by necessity, or individual traders who wish to make the most of the opportunities offered by options. This is not meant to discourage those who ate casually or peripherally involved in options markets from teading this book. Additional insight into any subject is always worthwhile. But Understanding options requires substantial effort. The serious trader, because his livelihood often depends on this understanding, will usually be more willing to invest the time and energy required to attain this goal. In preparing the reader for the option marketplace, the author has tried to combine an intuitive approach to option theory with a discussion of the real-life problems with Which he will be confronted. Of course, the reader who is comfortable with mathemat- Icsis in no way. discouraged from delving more deeply into the theory of option pricing a