FPA IL CAP Conference 2014

Trading Options: Advanced Concepts

Lessons Learned from 30 Years of
Investing and Options Trading
Russell Rhoads, CFA ,
Senior Instructor, The Options Institute at CBOE

Copyright (c) 2014 CBOE. All Rights reserved

 Disclaimer & Disclosures
Options involve risks and are not suitable for all investors. Prior to buying or selling options, an
investor must receive a copy of Characteristics and Risks of Standardized Options. Copies are included
with this presentation and may be obtained by contacting your broker, by calling 1-888-OPTIONS, or at
www.theocc.com.
In order to simplify the computations, commissions, fees, margin interest and taxes have not
been included in the examples used in this presentation. These costs will impact the outcome of
all stock and options transactions and must be considered prior to entering into any
transactions. Multiple leg strategies may involve multiple commission charges. Investors should
consult their tax advisor about any potential tax consequences.
The information in this presentation, including examples using actual securities and price data,
is strictly for illustrative and educational purposes only and is not to be construed as an endorsement,
recommendation, or solicitation to buy or sell securities or to provide investment advice.
Supporting documentation for any claims, comparisons, statistics, or other technical data, will
be supplied upon request. Past performance is not a guarantee of future results. Annualized returns
cited might be achieved only if the parameters described can be duplicated and there is no certainty of
doing so. CBOE®, Chicago Board Options Exchange®, Execute Success® and VIX® are registered
trademarks and The Options Institute is a service mark of Chicago Board Options Exchange,
Incorporated (CBOE).
This presentation should not be construed as an endorsement or an indication by CBOE of the
value of any non-CBOE product or service used or described in this presentation. CBOE is not affiliated
with FPA of Illinois.
Copyright © 2014 CBOE. All rights reserved. 2
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 Session Outline

Volatility: The concept and three types

What it says about stock price moves
Probabilities of finishing and touching
Using volatility to set price targets
Income Generation: Helping clients develop
realistic expectations
Portfolio Protection: The real cost, the psychology
and ways to lower the cost

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 Volatility – The Concept

Insurance Options
Asset Value Stock Price
Deductible Strike Price
Time Time
Interest Rates Int. Rates & Div.
Risk Volatility
= Premium = Premium
Options are like insurance.
Volatility corresponds to risk.
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 Types of Volatility

Volatility means “movement,” but there are at

least three ways to think of movement:
Historical volatility
Realized (or future) volatility
Implied volatility

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 Historical Volatility

Stock price action in the past

38

High 36

34

32

Volatility 30

28

26

Low 38

36

34

Volatility 32

30

28

26

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 Realized Volatility

Stock price action in the future

(usually not the same as historical volatility)
Also called future volatility
Realized volatility is unknown today

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 Implied Volatility

The volatility percentage that justifies the

market price of an option
The volatility “in an option’s price”
Rising implied volatility means that the
“market expects something to happen”

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 Calculating an Option’s “Value”

XYZ stock 63.80 Theoretical Value

Strike Price 65.00 of 65 Call

Days to Exp 45 ??
Interest Rates 0.7%
Dividends -0-
Volatility 30.0%  Where does a trader
get this number?

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 Calculating Implied Volatility

XYZ stock 63.80 Market Price

Strike Price 65.00 of 65 Call

Days to Exp 45 1.85

Interest Rates 0.7% 
This is known.
Dividends -0-
Volatility ??  This is unknown.

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 Volatility Changes

#1 Stock price volatility: Investor emotions rise

and fall with economic, corporate and world
news. Sometimes investors “rush in or panic
out” of stocks. At other times they have near-
zero anxiety.
#2 Option implied volatility: As emotions rise and
fall, the relative price that investors are willing
to pay for options also rises and falls.
#1 and #2 do not always rise and fall together.
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 Volatility Changes

SPX

H.V.
&
I.V.

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 The Bell Curve

From Statistics –

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 Volatility – What it Means

Stated volatility is the annual standard deviation

68% of the time – in 1 year – the price will be
within 1 SD of today’s price
95% of the time – in 1 year – the price will be
within 2 SDs of today’s price
99% of the time – in 1 year – the price will be
within 3 SDs of today’s price

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 Stated Volatility = Annual Std. Dev.

S&P 500 (SPX) 1900.00

Days to Exp 365
Implied Volatility 12%
Stock Price  I.V.   Days to Exp
 Days per year
100.00  .12   365
= 228.00
 365

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 Converting the 1-Year Std. Dev.

S&P 500 (SPX) 1900.00

Days to Exp 60
Implied Volatility 12%
Stock Price  I.V.   Days to Exp
 Days per year
100.00  .12   60
= 92.45
 365

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 Converting the 1-Year Std. Dev.

SPX 1,900; Days 60; Stated Vol 12%; 1 SD 92.00

68% of the time – in 60 days – SPX will be
between 1,808 and 1,992
± 1 SD (1,900 – 92) (1,900 + 92)
95% between 1,716 and 2,084
± 2 SDs (1,900 – 184) (1,900 + 184)
99% between 1,624 and 2,176
± 3 SDs (1,900 – 276) (1,900 + 276)
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 1 S.D. – Quick & Dirty – The Straddle

Buy 1 100 Call @ 3.35 & Buy 1 100 Put @ 3.30

10
8
6
4
2
0
-2 90 95 100 105 110

-4
-6
-8

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 1 S.D. – Quick & Dirty – The Straddle

Underlying Price 35 60 123

Strike Price 35 60 125
Days to Exp. 35 28 51
Int Rate/Div Yld 1.2/0 1.2/0 2.0/4.0
Volatility 35% 50% 43%
1 Std Dev 3.79 8.31 19.77
Call Price 1.53 3.34 6.80
Put Price 1.49 3.28 9.13
Straddle 3.02 6.62 15.93
Straddle / S.D. ? ? ?
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 1 S.D. – Quick & Dirty – The Straddle

The at-the-money straddle price is 80% of 1 SD.

This is based on implied volatility, which is determined
by the supply and demand in the market.
This calculation of SD is “what the market thinks.”

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 The Bell Curve

What the bell curve tells you –

68.2% of the time, a stock should land between
up and down 1 SD at expiration
95% of the time, a stock should land between
up and down 2 SD at expiration
Conclusion: Options with strike prices 1 SD out of the
money expire worthless 84% of the time. But
how much do they increase in price 16% of the
time?
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 The Bell Curve

What the bell curve does not tell you –

What path does the stock take between now
and expiration?
How often is a standard deviation level violated?
What happens once a standard deviation is
violated?

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 Probabilities

(probabilities of “finishing”)
1 Close between up 1 SD and down 1 SD at exp 68%
2 Close between up 2 SD and down 2 SD at exp 95%
3 Close between up 3 SD and down 3 SD at exp 99%

(probabilities of “touching”)
4 Touch up or down 0.5 SD prior to expiration 99%
5 Touch up or down 1.0 SD prior to expiration 54%
6 Touch up or down 1.5 SD prior to expiration 22%
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 Probabilities

6 Touch up or down 1.5 SD prior to expiration 22%

7 Touch up or down 2.0 SD prior to expiration 7%

8 Touch both up and down 0.25 SD prior to exp 36%

9 Touch both up and down 0.50 SD prior to exp 14%

10 Close beyond 1.0 SD after touching 1.0 SD 58%

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 Using the Probabilities

Probabilities #4 & #8, imply:

If the underlying touches 0.25 SD, then there

is a 64% chance the underlying will continue to
0.50 SD in the same direction without reversing
to touch the 0.25 SD in the opposite direction.

Therefore, there is a statistical advantage to following the

trend when the underlying touches 0.25 SD.
(At the least, this is a decision point.)
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 Using the Probabilities

If you are bullish on a stock…..

Wait for it to rise 0.25 SD, then buy it.
You then have a 64% chance it will continue rising.

If you buy a stock…..

Down 0.25 SD is a logical level for a stop-loss.
There is a 64% chance it continue falling.

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 Income Generation

“Sell options to generate income.”

Covered calls
Cash-secured puts
The hard question:
If the market is efficient, why does selling options
“increase income”?
ANSWER: Selling options does not “beat the market.”
It allocates part of the return to realized
cash income instead of capital gains.
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 Income Generation

CBOE created indexes to track option-selling strategies

BXM: Own an S&P 500 Portfolio and
Sell 30-day at-the-money SPX Calls
BXY: Own an S&P 500 Portfolio and
Sell 30-day 2% out-of-the-money SPX Calls
PUT: Hold T-Bills equal to the S&P 500 Index and
Sell 30-day at-the-money SPX Puts

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 CBOE S&P 500 BuyWrite Index
$100 Invested in BXM and SPXTR

June 30, 1988 – July 31, 2014

1400

1200

CBOE S&P 500

1000
BuyWrite Index (BXM)
800

600

400

S&P 500 Total

200 Return (SPXTR)

0
1988 1991 1994 1997 2000 2003 2006 2009 2012

Data Source: Bloomberg

CBOE OPTIONS INSTITUTE 29
 CBOE S&P 500 2% OTM BuyWrite Index

$100 Invested in BXY and SPXTR

June 30, 1988 – July 31, 2014

1600

1400

1200 CBOE S&P 500 2% OTM

BuyWrite Index (BXY)
1000

800

600

400
S&P 500 Total
200
Return (SPXTR)

0
1988 1991 1994 1997 2000 2003 2006 2009 2012

Data Source: Bloomberg

CBOE OPTIONS INSTITUTE 30
 CBOE S&P 500 PutWrite Index
$100 Invested in PUT and SPXTR

June 30, 1988 – July 31, 2014

1600

1400

1200 CBOE S&P 500

PutWrite Index (PUT)
1000

800

600

400

S&P 500 Total

200
Return (SPXTR)
0
1988 1991 1994 1997 2000 2003 2006 2009 2012

Data Source: Bloomberg

CBOE OPTIONS INSTITUTE 31
 Income Generation – Example 1

Stock Price 100.00

Days to Exp 90
Volatility 20%
1 Std Dev ≈ 10 (100 x .18 x √90 ÷ √365)
½ SD OOM Call
105.00 Strike 2.05 (8.2% ROR)
½ SD OOM Put
95.00 Strike 1.85 (7.4% ROR)

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 Income Generation – Example 2

Stock Price 100.00

Days to Exp 90
Volatility 24%
1 Std Dev ≈ 12 (100 x .24 x √90 ÷ √365)
½ SD OOM Call
106.00 Strike 2.50 (10.0% ROR)
½ SD OOM Put
94.00 Strike 2.25 (9.0% ROR)

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 Income Generation – Example 3

Stock Price 100.00

Days to Exp 90
Volatility 28%
1 Std Dev ≈ 14 (100 x .28 x √90 ÷ √365)
½ SD OOM Call
107.00 Strike 2.90 (11.6% ROR)
½ SD OOM Put
93.00 Strike 2.55 (10.2% ROR)

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 Income Generation – Summary

Implied Volatility Est ROR Call Est ROR Put

20% 8.2% 7.4%
24% 10.0% 9.0%
28% 11.6% 10.2%
Conclusion? Many people look for high volatility,
because it “makes more money.”
But these stocks have the same
probability of moving twice as much.
Stock picking is an art, not a science.
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 Protecting a Diversified Portfolio

Your client has a $1,800,000 portfolio that

closely follows the SPX now at 2,000
You are worried about a 15% market decline in
the next 3-4 months.
You want to limit downside risk and keep the
upside.

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 Protecting a Diversified Portfolio

Determine # of SPX contracts:

Portfolio $Value to be Hedged
Notional Value of Index Contract (Strike x $100)
$1,800,000
= ??
2,000 x $100

Buy 9 SPX Dec 2000 Puts @ $60.00 ($6,000/Contract)

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 Protecting a Diversified Portfolio
$1,800,000 Portfolio
SPX @ 2,000

9 SPX ________
Buy____ 60.00
Dec 2000 Puts @ ______
9 x 60 x $100 = $54,000
Cost = __________________________
 3.0% of portfolio value
1 SPX Put protects $200,000
Strike price is at the money
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 How the Protection Works

Assume SPX at 1,700 (down 15%)

Market is down 15% so portfolio is down 15%
$1,746,000 stock portfolio now $1,484,000
With SPX @ 1,700 300.00 each
2000 Puts @ __________
300.00 x 9 x $100 = $270,000
Value of puts = __________________________
Total Portfolio = 1,484,000 + 270,000 = 1,754,000
__________________________
Market down 15%. You are down 3%
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 The “Real Cost” of Protection

Imp. Vol. 4-mo ATM Put 4-mo 5% OOM Put

12% 2.7% 0.9%
16% 3.7% 1.4%
20% 4.6% 2.4%
24% 5.5% 3.2%
48% 11.0% 8.3%
The cost of ATM protection rises linearly with rising
implied volatility.
The cost of OOM protection rises exponentially with
rising implied volatility.
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 Unwilling to Pay for Puts?

Sell equity calls to pay for index puts

• Sell near-the-money calls on stocks that you are
willing to sell now.
• Sell out-of-the-money calls on stocks that you
are willing to sell if price rises.
• Sell calls on part of a stock position if you want
to “lighten up” or diversify.

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 Summary

Volatility Historical, Implied, Realized

Probabilities rule!
Income Realistic expectations are key
The goal is to get cash income
(not to beat the market)
Protection The cost is related to the level
of implied volatility

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 Trading Options: Advanced Concepts

THANK YOU FOR ATTENDING!

Visit us at: www.cboe.com

rhoads@cboe.com

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