Sheldon Natenbers OPTION VOLATILITY PRICING Cakes i Le) Strategies and Tec ues 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 regard to 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 ‘A Duvssion of The McGraw-Hill Compartes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 e1+ The Language of Options Contract Specifications Exercise and Assignment Market Integrity Margin Requirements Settlement Procedures Ze Elementary Strategies Simple Buy and Sell Strategies Risk/Reward Characteristics Combination Strategies Constructing an Expiration Graph e3e 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 Be Scoaonom 13 13 16 19 23 35 36 37 39 47 47 48 49vi Table of Contents o4e Volatility 51 Random Walks and Normai Distributions 51 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 67 A Note on Interest Rate Products 68 Types of Volatilities 69 ese Using an Option’s Theoretical Value 81 e6e Option Values and Changing Market Conditions 95 The Delta 99 The Gamma 103 The Theta 11 The Vega or Kappa £13 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 o8e Volatility Spreads 137 Backspread (also referred to as a ratio backspread or long ratio spread) 138 Ratio Vertical Spread (also referred to as a ratio spread, short ratio spread, vertical spread, or front spread) 139 Straddle 141 Strangle 143Table of Contents vit Butterfly 145 Time Spread (aiso referred to as a calendar spreador horizontal spread) 148 The Effect of Changing Interest Rates and Dividends 154 Diagonal Spreads 157 Other Variations 157 Spread Sensitivities 159 Choosing an Appropriate Strategy 161 Adjustments 168 Entering a Spread Order 169 oOo Risk Considerations 173 Choosing the Best Spread. 173 Practical Considerations 181 How Much Margin for Error? 187 Dividends and Interest 188 What Is a Good Spread? 192 Adjustments 193 A Question of Style : 195 Liquidity 196 2104 Bull and Bear Spreads 199 Naked Positions 199 Bull and Bear Ratio Spreads 199 Bull and Bear Butterflies and Time Spreads 201 Vertical Spreads 202 e11¢ Option Arbitrage 213 Synthetic Positions , 213 Conversions and Reversals 217 Arbitrage Risk 223 Boxes 228 Jelly Rolls 231 Using Synthetics in Volatility Spreads 233 Trading without Theoretical Values 235vitt 12% Early Exercise of American Options Futures Options Stock Options The Effect of Early Exercise on Trading Strategies 13% Hedging with Options Protective Calls and Puts Covered Writes Fences Complex Hedging Strategies Portfolio Insurance o14¢ Volatility Revisited Some Volatility Characteristics Volatility Forecasting A Practical Approach Some Thoughts on Implied Volatility e1ss 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 *16% 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Table of Contents be 217% Position Analysis 353 Some Simple Examples 353 Graphing a Position 358 A Complex Position 367 Futures Option Positions 372 218% Models and the Real World 385 Markets Are Frictionless 386 Interest Rates Are Constant over the Life of an Option 388 Volatility Is Constant over the Life of the Option 390 Trading Is Continuous 394 Volatility Is Independent of the Price of the Underlying Contract 399 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 400 Skewness and Kurtosis 402 Volatility Skews 405 A Final Thought 416 * Appendix A + A Glossary of Option and Related Terminology 419 ~ Appendix B ¢ The Mathematics of Option Pricing 431 Option Pricing Models 431 Normal Distributions 439 Volatility Calcwations 442 The Extreme Value Method 443 The Exponential and Natural Logarithm Functions 446 * Appendix C + Characteristics of Volatility Spreads 449 + Appendix D + What’s the Right Strategy? 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. Notonly 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 are 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- Ics is in no way discouraged from delving more deeply into the theory of option pricing cexi Preface in many of the excellent academic presentations of the subject. But the important point is that such a rigorous opproach is not necessary for success in option trading. Indeed, the great majority of successful option traders have never even looked at a mathematical presentation of option theory. Nor would many of them be capable of understanding the complex mathematics if they did. Much of the presentation in this book will necessarily be colored by the author's personal experiences as a floor trader. Sophisticated hedging strategies, such as portfolio insurance, and complex intermarket spreading strategies are touched upon only briefly, ifat all. Yet the principles of option evaluation which enable a floor trader to successfully Participate in an option market are the same principles which will enable any participant to make the best use of options, regardless of the reasons for entering the market. Additionally, the author is able to place special emphasis on a lesson which floor traders quickly learn but which casual traders too often forget. Without a very healthy respect for the risks of option trading and a full understanding of risk management techniques, today’s profits can quickly turn into tomorrow’s losses. Because of the more recent introduction of listed options on futures contracts and the increased interest in these markets, the author has tended to concentrate the examples in the text on these options. However, the principles which lead to success in futures options are equally valid in commodity, stock, and index option markets. The core material in this book was developed in classes taught by the author to traders at the Chicago Board of Trade. In expanding the material into book form the author has tried to draw on a wide variety of other sources. Foremost among these are the many floor traders who offered their comments and criticisms. In addition, special thanks go to Greg Monroe of the Chicago Board of Trade Education Department and Mark Rzepezynski of the Chicago Mercantile Exchange Research Department for their comments on the text, and to David Isbister of Monetary Investments International for preparation of some of the values used in the tables. Finally, my thanks to the staff at Probus Publishing for their encouragement, patience, and assistance in dealing with a first time author. Sheldon Natenberg ChicagoPreface to the Second Edition + Jn 1986, when I first discussed with Probus Publishing the idea of an option book for professional traders, there was considerable doubt as to whether there would be sufficient interest to justify publication of such a book. After all, how many professional option traders are there? To everyone’s (pleasant) surprise, when the book came out not only did it turn out that a large number of professionals were purchasing the book, but many non-professionals also seemed to be very interested in this approach. The revised edition is no different in its focus. The new material is likely to be of greatest interest to the serious option trader. While the material may also be of interest to the non-professional, it is the professional, whose livelihood depends on a complete understanding of options, who will be most willing to spend the time required to master the material. In the new edition I have tried to incorporate the comments and suggestions which traders have made concerning the first edition. Some of the more important additions: Expanded coverage of stock options—When I sat down to write the first edition the emphasis was on commodity options. This was primarily a marketing decision. At the time there were several books available on stock options, but hardly any commodity options. However, with the success of the first edition, and at the suggestion of many friends at the CBOE, I felt it would be worthwhile giving stock options equal emphasis. More on volatility—Given its importance, a second chapter on volatility has been added with more detailed discussion of volatility characteristics and considerations. A chapter on stock index futures and options—These markets have become so important, and are so interconnected, that some discussion is mandatory in any book on options, While one chapter cannot possibly cover every aspect of index markets, 1 have tried to touch on how these markets differ from traditional option markets, and the effect of these differences on trading strategies. A discussion of intermarket spreading—Much of the most sophisticated trading involves spreading options in one underlying market against options in a different Underlying market. I have included a discussion on the relationship between similar underlying markets, and the methods traders use to construct spreads when a relation- Ship appears to be mispriced. A more detailed discussion of volatility skews—This is probably the one area about Which I am most often asked, the tendency of different exercise prices to trade at different implied volatilities. | have tried to include a discussion of this phenomenon, 4nd several methods by which traders deal with this problem. xtxiv Preface Ihave also deleted two appendicies: A guide to software—New software is being introduced so quickly that it did not seem practical to include a list of vendors and products as J did in the first edition. Nor am I familiar with every piece of software available, so it would be unfair to those vendors who have good products but whom | might inadvertantly omit, The best way for traders to choose software is to talk to other traders and to read some of the industry periodicals to find out what programs are being used to evaluate options. Historical volatilities—When the first edition came out | suspected that some new traders might not have access to any volatility data, so | included some historical volatility graphs for selected futures contracts. Now, however, volatility data in some form is available to almost all option traders so | did not feel that volatility charts, which would quickly become outdated, would be worth including, Asin the first edition, I make no claims to being a theoretician, and this book is not intended to take the place of a good book on option theory. But theory is only important 88a Means to an end—the actual trading of options in the marketplace. Whatever theory is in the book, I have tried to present in non-technical language. For a more complete discussion of option pricing theory, the reader can consult any of the advanced books to be found in Appendix F. Nor is it my intention to make decisions for the reader or to tell the reader how to trade. There are many ways to trade successfully in an option market. Regardless of a trader’s own style, without a complete familiarity with the necessary tools, and a proficiency in their use, it is almost impossible to be successful in options. I have tried to explain what these tools are, how they work, and the variety of ways in which traders use them to make decisions that fit their own individual needs and trading styles. In doing so, I have attempted, as much as possible, to avoid contaminating the reader with my own personal preferences and prejudices. Ina sense, nothing in either this or the first edition of Option Volatility and Pricing Strategies is new. All the theory, trading strategies, and risk management considera- tions, are familiar to experienced traders in one form or another. My goal has been to put all this material together and present it in an orderly, easily understandable format which I hope will form a solid foundation upon which an aspiring option trader can build a successful career. This book is a result not only of my efforts, but of the efforts of the many traders who were kind enough to read this material and offer their comments and suggestions. Without their help | could not hope to cover all the important aspects of options. To all of them, and to the editors at Probus Publishing Company, who displayed patience above and beyond the call of duty, | offer my thanks and enduring gratitude. Sheldon Natenberg Chicago Sune 1994~1e The Language of Options Every option market brings together traders and investors with different expectations and goals. Some enter the market with an opinion on which direction prices will move. Some intend to use options to protect existing positions against adverse price move- ment. Some hope to take advantage of price discrepancies between similar or related products. Some act as middlemen, buying and selling as an accommodation to other market participants and hoping to profit from the difference between the bid and ask rice. , Even though expectations and goals differ, every trader’s education must begin with an introduction to the terminology of option trading, and to the rules and regulations which govern trading activity. Without a facility in the language of options, a trader will find it impossible to communicate his desire to buy or sell in the marketplace. Without a clear understanding of the terms of an option contract, and his rights and responsibilities under that contract, a trader cannot hope to make the best use of options, nor will he be prepared for the very real risks of trading. CONTRACT SPECIFICATIONS Options are of two types. A call option is the right to buy or take a fong position in a given asset (typically a security, commodity, index, or futures contract) at a fixed price on or before a specified date, A put option ts the right to sell or take a short position in @ given asset. Note the difference between an option and a futures contract. A futures contract Tequires delivery at a fixed price, The buyer and seller of a futures contract both have obligations which they must meet. The seller must make delivery and the buyer must take delivery of the asset. The buyer ofan option, however, has a choice. He can choose to take delivery (a call) or make delivery (a put). If the buyer of an option chooses to either make or take delivery, the seller of the option is obligated to take the other side. In option trading all rights lie with the buyer and all obligations with the seller. ‘The asset to be bought or sold under the terms of the option is the underlying asset Or, more simply, the underlying. The exercise price, or strike price, is the price at which the underlying will be delivered should the holder of an option choose to exercise his Tight to buy or sell, The date after which the option may no longer be exercised is the expiration date.