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Most investors are familiar with options as powerful hedging tools suitable for protecting equity or exchange-traded fund positions. Others have explored options further by enhancing their positions through call and put writing. Regardless of the approach, another attribute of options is that they allow investors to benefit from the power of leverage, providing notional exposure to an underlying for a fraction of the actual cost. Before fully exploring the dynamics of this exposure, let us review some important elements of options trading. A common misconception is that the price change, known as delta, of a call relative to the underlying stock happens at a 1-1 ratio (delta = 1) for all underlying prices above the call’s strike. This is only the case very near to or at expiration or at strike prices at or further out than expected volatility. The reality is that with more time to expiration, underlying prices have a greater chance of deviating from their current price levels. Accordingly, the delta of the at-the-money (ATM) contract is 0.5 (a 0.5-1 ratio price move as compared with the underlying) and why any ATM trade is also referred to as the “50 delta trade.” At a high level, the combination of the option contract moving deeper in the money and closer to expiration comes together to raise the contract’s delta toward 1. Consider Figures 1 and 2 (data provided as of authoring of article). The only major difference between these two tables is the time to expiration. Figure 1 shows contracts 45 days from expiration, while Figure 2 shows contracts 10 days from expiration. What is interesting is that while the delta of the ATM strike is roughly the same for both expirations, the 145 strike delta is almost five times as much for the 45-day expiration as it is for the 10-day expiration. Also, it seems like the market is convinced that underlying prices equal to or less than 130 are not expected to be realized regardless of time frame. Figure 1 SPY Calls, 45 Days To Expiration (SPY@ $140) Strike Price Source: Bloomberg Figure 2 SPY Calls, 10 Days To Expiration (SPY@ $140) Strike Price Source: Bloomberg Call Price Call Price Delta 145 $0.82 0.24 140 $3.02 0.54 136 $5.82 0.73 130 $11.00 1.00 Delta 145 $0.06 0.05 140 $1.42 0.57 136 $4.63 0.91 130 $10.48 1.00 In the above example, we see how delta represents the sensitivity of changes in an options contract’s price to changes in the price of the underlying. Three other options Greeks—vega, theta and rho—represent options price sensitivity to a 1 percent change in volatility, change in time to expiration and a 1 percent change in interest rates, respectively. The fifth and final Greek is gamma, which represents the rate of change of delta as underlying prices move. Out-of-the-money (OTM) contracts tend to have low delta and high gamma, while ATM and in-the-money (ITM) contracts have increasingly higher delta and lower gamma. Delta moving 0.05 from 0.05 to 0.10 equates to gamma of 1 (“100 gamma”), whereas delta moving 0.05 from 0.5 to 0.55 equates to gamma of 0.1 (“10 gamma”). How can the Greeks assist in explaining the observations made earlier in the comparison of Figures 1 and 2? Without devolving into yet another treatise on the Black-Scholes options pricing model, suffice it to say that while the price of the underlying, volatility of price of the underlying, time-to-expiration and prevailing interest rate all contribute to options contract price discovery, the volatility of underlying price changes drives this equation. Current observed, or historical, 10- and 45-day volatilities of SPY are each approximately 15 percent, which means that over any given 10- or 45-day period in the past year, investors could reasonably expect (68 percent of the time given a normal distribution) a 15 percent movement around any given price of SPY. In considering just the left tail of this distribution, this translates to an expected 7.70 percent move, or in this case, about $10 given the current $140 SPY price. This explains the 100 delta for contracts at or below the 130 strike regardless of time-to-expiration. Given that both observed volatilities in prices of SPY are held constant when considering any of the contracts in question, as are interest rates, the only variable left is timeto-expiration. That there is more time-to-expiration explains why the delta of the August 145 call is 0.05 while the delta of the September 145 call is 0.24: There is simply more time for the unknown to become known. Consider a 100-share position of SPY at $140 per share. This position has a notional value of $14,000. What if an investor didn’t have or didn’t want to tie up $14,000 but still wanted exposure to the price movement of 100 shares of SPY? To participate in the upside of this trade for approximately the next month would require getting exposure to the ATM SPY call expiring as close to one month from now as possible. The call in question would be the SPY 140 September call. This contract is priced at $2.93 per share and, with option contracts almost always representing notional exposure of 100 shares per contract, the contract would cost $293. As the 140 strike call has a delta of roughly 0.5, investors would expect to observe roughly half of the price movement of the underlying reflected in the price of the option. To fully replicate exposure to 100 shares of SPY, an investor would have to purchase two calls in order to bring the overall position delta up to 1. November / December 2012 29
This concept is especially important when using options to hedge a position. Consider an existing position of 100 shares of SPY. The inexperienced investor seeking to fully hedge his position would purchase one ATM put and rest easy, until the anticipated downward move occurs and he is left pondering the source of his newly minted losses. It is only through hedging the portfolio on a delta basis (delta-hedging) that it will be fully protected. These positions are examples of debit strategies, or strategies that leave investors’ accounts with debits as they are paying for access to these positions. Credit strategies are those trades that produce a net credit in investors’ accounts as they involve the writing, or selling, of option contracts. Writing or selling options has been a strategy that is becoming increasingly popular with investors as a way to enhance returns on their existing positions. However, writing options obligates the writer to deliver or take receipt of underlying shares if the contract is exercised or assigned. If options are written against existing positions (covered either by shares or cash), then the investor may be forced to either deliver his position against the open written call or receive (purchase from the holder of the put contract) shares to close out the written put. If options are written without any collateral, they are said to be “naked.” Writing naked options can quickly lead to great financial success, as the writer could end up keeping the entire collected premium as the contracts written expire worthless, or to financial ruin as the writer could be on the hook for the difference between the underlying share price less the contract strike less collected premium. Theoretically, this obligation could be infinite. Consider the ATM September 140 SPY call. If an investor were convinced that SPY was destined to trade off sharply, he might consider selling this call. If he is correct, he realizes a gain of $293 at expiration for each contract sold. If he is incorrect, he must deliver 100 shares of SPY at $140 per share regardless of the prevailing price. For example, if SPY is trading at $160 at any point prior to expiration, he would have to purchase shares in the open market at $160 and deliver (sell) them to the buyer of his contract for only $140. Multiply this scenario by 10 and you can see why the possibility of earning $2,930 is quickly outweighed by the possibility of having to source $160,000 and immediately lose $17,070 ($20,000-$2,930) on the transaction. This is why most brokerage houses permission their clients’ options activity in tiers, with naked option writing being one of the highest-level activities allowed. An easy way to mitigate the risk of this lopsided trade is through a spread trade. Spread trades can take any number of forms, such as vertical spreads, horizontal (calendar) spreads, back spreads or ratio spreads, to name a few. We are going to consider the vertical spread trade; specifically, the vertical bear call spread and the vertical bull put spread. The vertical bear call spread is a neutral-to-bearish multileg options strategy (Figure 3). Premium is collected through the sale of a call (obligation to deliver the underlying stock). Part of the premium received is used to buy a call (right to buy the underlying stock) at a higher strike price. Selling a call theoretically represents unlimited risk. Buying a call limits the risk to the difference between the sold and bought strike prices (strike spread) less any premium collected. For example: SLD: SPY NOV 140 CALL @ 4.20 (receive $420) BOT: SPY NOV 143 CALL @ 2.62 (pay $262) Net Credit: $420 - $262 = $158 $-At-Risk: Difference in Strikes – Net Credit ((143 – 140) x 100) - $158 = $142 MAX Gain/Loss: Max Gain = $158 (52.67%) / Max Loss = $142 (-47.33%) Collateral for this position would generally be determined by the strike spread. Collateral of $300 would be Figure 3 $6 $5 $4 $3 $2 $1 $1 $2 $3 $4 $5 $6 Figure 4 $6 $5 $4 $3 $2 $1 $1 $2 $3 $4 $5 $6 Proft - - Loss Source: : ISE Proft - - Loss Source: : ISE ■ Short Call ■ Long Call ■ Payof Max Loss = $1.93 ■ Short Put ■ Long Put ■ Payof Options – Vertical Bear Call Spread SPY NOV 140 CALL @ 4.20 Max Gain = $1.58 SPY NOV 143 CALL @ 2.62 Outlook: Neutral to Bearish The Trade: Sell Call; Buy Call @ Higher Strike Risk: Strike Spread—Premium Received Reward: Premium Received Break Even Point: Premium Paid—Premium Received Options – Vertical Bull Put Spread Outlook: Neutral to Bullish The Trade: Sell Put; Buy Put @ Lower Strike Risk: Strike Spread—Premium Received Reward: Premium Received Break Even Point: Premium Paid—Premium Received SPY NOV 137 PUT @ 3.45 SPY NOV 140 PUT @ 4.55 Max Gain = $1.10 Max Loss = $1.42 Stock Price Stock Price 30 November / December 2012
Page 1 and 2: Plus Blitzer on the history of opti
Page 3: Contributors Mark Abssy Mark Abssy
Page 6 and 7: STOXX LIMITED INNOVATIVE INDEXING.
Page 8 and 9: People’s futures are in your hand
Page 10 and 11: ©2012 Morningstar, Inc. All rights
Page 12 and 13: Exchange-traded products span a wid
Page 14 and 15: Figure 5 Median notional Volume ($B
Page 16 and 17: the put spread in this example is $
Page 18 and 19: The Loch Ness Monster. Sightings of
Page 20 and 21: TAKE A NEW LINE WITH YOUR EQUITY Po
Page 22 and 23: Over the past 12 years, U.S. invest
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Page 26 and 27: 500 BuyWrite Index (BXM)—was anno
Page 28 and 29: volatility that was about 30 percen
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Page 34 and 35: THE POWERSHARES DB COMMODITY INDEX
Page 36 and 37: Depression was history, rather than
Page 38 and 39: academic assessment of the very exi
Page 40 and 41: Alternative Investments 4.0% Real E
Page 42 and 43: tion and management. Within it, an
Page 44 and 45: Much ink has been spilled on the pe
Page 46 and 47: Figure 1 sectors No. of top dogs Re
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Page 50 and 51: States, the average concentration p
Page 52 and 53: Figure 10 sectors Source: Research
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Page 58 and 59: open the Etracs Long-Short S&P 500
Page 60 and 61: Morningstar Index Funds U.S. Style
Page 62 and 63: Exchange-Traded Dow Jones U.S. Indu
Page 64 and 65: ETF Analytics Your clients want mor
Page 66 and 67: PICK THE HIGH HANGING FRUIT. Find 1
Page 68 and 69: InsideETFs portFolio management str
Page 70 and 71: ©2012, THE NASDAQ OMX GROUP, INC.
Page 72: Crossword Thinking About Options Te

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