Implied Volatility and Profit vs. Loss 1-888-OPTIONS www.OptionsEducation.org Viewing Time: 17 minutes

Implied Volatility and Profit vs. Loss Options involve risks and are not suitable for everyone. Prior to buying or selling options, an investor must receive a copy of Characteristics and Risks of Standardized Options. Copies may be obtained by contacting your broker or The Options Industry Council at One North Wacker Drive, Chicago, IL 60606. In order to simplify the computations, commissions, fees, margin interest and taxes have not been included in the examples used in these materials. These costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax advisor about any potential tax consequences. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Past performance is not a guarantee of future results. Before we begin, I would like to make the following points. First, I am not a licensed broker or a registered investment advisor, so everything I say tonight is for educational purposes only. Nothing I say should be considered investment advice. Second, the examples in the presentation do not include transactions costs, but they are important to consider in real life strategies. Finally, the options disclosure document “Characteristics and Risks of Standardized Options” is included in you packet of materials. Please read this thoroughly before engaging in any options transactions. Questions? Now let’s get into the presentation

Presentation Outline Volatility review what is volatility? kinds of volatility effects of changing implied volatility on calls and puts implied volatility and stock price variance Measuring changes in implied volatility vega Implied volatility in the marketplace implied volatility behavior implied volatility and your positions Long and short options: Hypothetical Examples Here is an outline of what I will discuss this evening. After a very brief review of the basics, we will focus specifically on spread strategies. This is not a basic-level seminar, so if you have never traded options, then some of this may be too complicated. The Options Investigator is the software disk included in your materials, and can be a useful tool to analyze option prices and option strategies. Please feel free to raise your hand and to ask questions at any time. My goal is to make sure you get what you need to feel good about coming here tonight.

Volatility Review Volatility represents price fluctuation of underlying stock over time no bias for up or down move quantified as one standard deviation price change (in %) 2 stocks over time begin and end at same price Which stock is more volatile?

Volatility Review Key factor of pricing model and theoretical values input for model is an assumption shorter-term options ─ key unknown longer-term options ─ key unknown (+ interest risk) Increasing volatility option buyers pay more for more stock fluctuation option sellers want more for increased risk Decreasing volatility buyers pay less for smaller fluctuation sellers take less for decreased risk

Historical and Expected Volatility Historical volatility underlying stock fluctuation observed and measured over time ─ usually 1 year can be recalculated daily ─ will change a fact, not a prediction Expected volatility prediction of future stock price fluctuation totally subjective ─ your call ultimately History may or may not repeat itself!

Implied Volatility Applies to options volatility assumption at which option is currently priced may be determined via option pricing model consensus of marketplace not necessarily right or wrong Can be at great variance with historical volatility may be highly dynamic may change intraday ─ sometimes significantly may or may not come “in line” with historical may apply to single option series or class of options

Effects of Changing Volatility Change in Volatility (Implied or Assumed) Call Prices Put Volatility ↑ ↑ Volatility ↓ ↓ Reflects expected variance in stock price over option’s lifetime more variance – potentially greater profits for buyers Volatility assumption (historical, expected, implied) expressed as standard deviation in % form (e.g. 30%) annualized

Volatility as Expected Variance in Underlying Stock Price Example: XYZ currently at $60 volatility assumption 30% In one year’s time XYZ to trade in range between $42 and $78 (± 30%) ≈ 68% of time (1 standard deviation) therefore, only ≈ 32% outside this range Bear this in mind when assessing implied volatility levels when pricing an option yourself

Measuring Changes in Implied Volatility Good evening. My name is ___________________, and am a ________ with the _______________ exchange. Tonight, I represent The Options Industry Council, which is a consortium of six options exchanges and The Options Clearing Corporation that have combined efforts to bring you this series of educational seminars. OIC is now 12 years old, and we have spoken to over 500,000 people. Can you please tell me a little about who you are and your investment experience. Please raise your hand if you have any experience trading options. Thank you. And how many of you make more than 5 trades per month. And how many of you have traded spreads? Thank you, that gives me some idea. This evening I plan to talk until 7:20-7:25 and then we will take a 15 minute break. After the break I will talk until about 9:00. There is a seminar evaluation form, which can be found in the front of your manual. Please take a moment at the end of the seminar to fill out the evaluation.

Vega (aka kappa or omega) Sensitivity of option price to change in volatility generated by option pricing model change expected in price for ±1%-point (percentage point) change in implied expressed in dollars and cents theoretical in nature Implied up 1%-point  calls/puts up by vega amount Implied down 1%-point  calls/puts down by vega amount

Vega Example XYZ at $60 XYZ 3-month 60 call (or put) at $3.70 90 days until expiration XYZ 3-month 60 call (or put) at $3.70 implied volatility = 30% vega = 0.118 (≈ 12¢) Implied volatility up to 31% call (or put) price up to $3.70 + $0.12 = $3.82 Implied volatility down to 29% call (or put) price down to $3.70 - $0.12 = $3.58

Effect of Vega Any increase or decrease in option price due to changing implied volatility is in time value only In-the-money options least time value – small dollar and percentage changes At-the-money options most time value – largest dollar changes Out-of-the-money options all time value – largest percentage changes

Implied Volatility in the Marketplace

See the Future? Changing volatility not necessarily predictable May be influenced by (among other things): news or rumors on underlying stock world events (political or military) volatility of broad market If you expect change in implied volatility levels degree of change can surprise timing of change can be swift\ Allow for changing volatility when buying/selling experience is best guide

Rules of Thumb Buy low, sell high Buy rumor, sell fact when implied is low many investors will buy when implied is high many investors will sell be aware of past implied volatility levels to judge again, your call Buy rumor, sell fact public rumors of upcoming news can drive implied up when news is announced, implied levels often drop When underlying drops, implied levels increase

Implied Volatility – More than Variance? Implied volatility is a consensus all market participants in the mix some expecting/predicting underlying volatility change supply and demand also a factor Supply and demand more buyers than sellers  prices up  implied up more sellers than buyers  prices down  implied down possibly reflects expected up/down trend for stock not necessarily reflects expected change in stock volatility this effect may be short-term, even intraday

Implied Volatility and Your Position Changes in implied affect time value can impact profit or loss during position’s lifetime During lifetime, implied volatility increases? buyers may take earlier profits sellers may feel pressured to stem losses During lifetime, implied volatility decreases? buyers may feel pressured to stem losses sellers may take earlier profits At expiration, options have intrinsic value or not implied volatility is moot at this point

Implied Volatility and Your Position Option buyers expect favorable move in underlying want implied volatility to increase implied increase may offset time decay exit plan: should allow for implied to drop Option sellers want implied volatility to decrease implied decrease may add to time decay exit plan: should allow for implied to rise

Implied Volatility and Your Forecast Include changing implied in your forecast? If wrong about stock move and right about implied may not see losses, or may lose less than you could have If right about stock move and wrong about implied may not see profits, or may see less profits than you could have

Hypothetical Examples Long and Short Options Hypothetical Examples

Long Call Buy XYZ 3-month 60 call at $3.70 XYZ at $60 – implied volatility 30% After 1 month → XYZ still at $60 implied down to 25% = call at $2.50 ← implied remains 30% = call at $3.00 implied up to 35% = call at $3.50 ← Increased Loss Decreased Loss

Long Call Buy XYZ 3-month 60 call at $3.70 XYZ at $60 – implied volatility 30% After 1 month → XYZ up to $65 implied down to 25% = call at $5.90 ← implied remains 30% = call at $6.30 implied up to 35% = call at $6.70 ← Decreased Profit Increased Profit

Long Call Buy XYZ 3-month 60 call at $3.70 XYZ at $60 – implied volatility 30% After 1 month → XYZ down to $55 implied down to 25% = call at $0.65 ← implied remains 30% = call at $1.00 implied up to 35% = call at $1.40 ← Increased Loss Decreased Loss

Covered Call Sell XYZ 2-month 65 call at $1.90 XYZ at $62 – implied volatility 30% After 1 month → XYZ still at $62 implied down to 25% = call at $0.75 ← implied remains 30% = call at $1.00 implied up to 35% = call at $1.35 ← Increased Profit Decreased Profit

Decreased Profit on Option Covered Call Sell XYZ 2-month 65 call at $1.90 XYZ at $62 – implied volatility 30% After 1 month → XYZ down to $57 implied down to 25% = call at $0.01 ← implied remains 30% = call at $0.15 implied up to 35% = call at $0.30 ← Cover and Sell Another Call? Decreased Profit on Option Changed verb from increased to reduced loss

Decreased Loss on Option Increased Loss on Option Covered Call Sell XYZ 2-month 65 call at $1.90 XYZ at $62 – implied volatility 30% After 1 month → XYZ up to $67 implied down to 25% = call at $3.10 ← implied remains 30% = call at $3.50 implied up to 35% = call at $3.85 ← Decreased Loss on Option Increased Loss on Option Cahnged for Increased Profit to Increased Loss

Profiting from Changing Implied Volatility Volatility Plays Profiting from Changing Implied Volatility

Increasing Implied Volatility Buy straddle XYZ at $60 buy 2-month 60 straddle at $5.80 implied at 30% After 2 weeks → XYZ still at $60 implied down to 25% → straddle at $4.25 implied remains 30% → straddle at $5.10 implied up to 35% = straddle at $5.90 ← Profit on Volatility Increase Alone

Increasing Implied Volatility You might also consider: Long strangles (versus long straddles) cheaper to buy – less risk profits may be less – bought out-of-the-money options bigger move needed to profit from underlying price change if implied fails to increase For short-term trading short time spreads short butterflies

Decreasing Implied Volatility Sell straddle XYZ at $55 sell 1-month 55 straddle at $3.80 implied at 30% After 2 weeks → XYZ still at $55 implied down to 25% → straddle at $2.30 ← implied remains 30% → straddle at $2.75 implied up to 35% → straddle at $3.20 Increased Profit from Volatility Drop

Decreasing Implied Volatility You might also consider: Short strangles (vs. short straddles) selling out-of-the-money options less risk but less profit potential bigger move needed to lose from underlying price change if implied fails to decrease Long time spreads Long butterflies and condors

Conclusion

Conclusion Understand ramifications of implied volatility vega implications for underlying price variance Be familiar with implied volatility behavior factors that can affect it When establishing a position know current implied level compared to past levels account for favorable or unfavorable implied changes Expect the unexpected implied levels can change abruptly and significantly

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