Reference (apr02) Single Stock Option’s Seminar Part I Option Trading Overview By Steve D. Chang Morgan Stanley Dean Witter Part II Volatility Trading Concept and Application By Charles Chiang Deutsche Bank A.G.

Reference (apr02) Volatility Trading Concept and Application By Charles Chiang Vice President, GED Trading, Deutsche Bank

Reference (apr02) 3 Index Option Trading Strategies What Is Volatility? Volatility and Option Pricing Delta-Neutral Strategy Case Study 1 Case Study 2 Risks in Volatility Trading Application of Option Volatility Trading –Option Risk Management –Equity Derivative Structured Product Summary and Appendix (introduction on Deutsche Bank A.G.)

Reference (apr02) 4 Option Trading Strategy Leverage Trading / Directional Trading Strategy – buy call, sell put, call spread, etc – buy put, sell call, put spread, etc Take a view on the market direction Take a view on the market volatility Volatility Trading Strategy

Reference (apr02) 5 What Is Volatility? A measure of the degree of the fluctuations Intuitively, which one do you think is more volatile? For example, compare the two listed companies in Taiwan – TSMC (ticker: 2330) – Chung Hwa (ticker: 2412)

Reference (apr02) 6 –Daily volatility What Is Volatility? –Annual volatility Volatility in statistical language

Reference (apr02) 7 Volatility and Option Pricing Option price is influenced by – Underlying Stock Price – Strike price – Maturity – Interest rate – Dividend – Volatility Assume that all the other factors are equal, will you pay the same price for the option written on TSMC and Chung Hwa?

Reference (apr02) 8 Volatility and Option Pricing The price of a call option increases when the underlying stock becomes more volatile. Actual Volatility Option Pricing Model Fair Value of Option Implied Volatility Option Pricing Model Market Value of Option – From buyers’ point of view, higher volatility means More chances to expire in the money; – From issuers’ point of view, higher volatility means Higher hedging cost Two types of volatility – implied volatility – actual volatility

Reference (apr02) 9 Delta-Neutral Strategy Delta Delta-neutral is the position where In a Delta-neutral position, small changes in stock price will not change the value of the stock-option portfolio. – An example

Reference (apr02) 10 Case Study 1 Buy 1,000 call option on TSMC. Assume that –European style, expire in two months; –Sold at the money; –One option exchanged for one share; –Interest rate r=2%p.a.; –No dividend will be paid; –actual annual volatility σ Y = 38%. Sell underlying stock to keep the portfolio Delta-neutral by rehedging it from time to time.

Reference (apr02) 11 Case Study 1 The benchmark for rehedging decision is σ D = 2.4%, which means Daily change of stock price < 2.4% Enjoy a leisure day Daily change of stock price  2.4% Adjust the stock position to achieve Delta-neutral In our example, altogether there are 10 rehedges during the two- months’ life of the call option

Reference (apr02) 12 When an investor buy an option whose implied volatility is lower than its actual one, he makes money no matter to which direction the market moves ! Case Study 1 When σ Y =38%, 48% and 28%, the outcomes of this strategy are: Fair Price

Reference (apr02) 13 Case Study 2 Now consider buying 1,000 options on Chunghwa and short sell the underlying stock to hedge. Assume that all factors are the same as in the example of TSMC, except that actual annualised volatility is 25%. when σ Y =25%, 35% and 15%, the results are as followed: Fair Price

Reference (apr02) 14 This is because the volatility of TSMC’s stock is higher than that of Chung Hwa’s. Case Study 2 Please note that the price for options written on Chung Hwa is relatively cheaper than that on TSMC (i.e. the former has a lower percentage price). Fair Price Fair Price

Reference (apr02) 15 Risks in Volatility Trading Volatility trading strategy may be subjected to potential loss if the writer/buyer of option estimates the market volatility incorrectly. –A single shock to stock price (e.g. 911 event, corporate action etc, whether positive or negative, may lead to great increase/decrease of the actual volatility of the underlying stock –The daily up and down limit on underlying stock may obstruct timely rehedging and other friction in the underlying market (transaction cost, bid/offer spread, liquidity) –Option model assumptions –Regulatory risks such as foreign ownership limit, short selling restriction

Reference (apr02) 16 Application of Option Volatility Trading Market makers usually reduce optionality risks by buying/selling options of same/different strike, maturity and hedge the net delta position between different options. For example –Option portfolio may consist of three parts:  Short call with higher implied volatility(C H )  Long call with lower implied volatility(C L )  Long underlying stock –The premium of C L eats up part of their profit –When market volatility moves up unexpectedly, the profit in C L partially offset the loss in C H (1) Option Risk Management

Reference (apr02) 17 Covered warrant risk management - buy short term single stock options to cover gamma risks in the the warrant book Index option volatility vs. single stock volatility - hedging or arbitrage between single stock volatility and index volatility CB volatility vs. single stock option volatility - take advantage on volatility differential between implied volatility from CB and single stock options Application of Option Volatility Trading (1) Option Risk Management — Examples

Reference (apr02) 18 One common example of equity derivative structured product is Equity Linked Note (ELN). Most popular examples are: – Principal Guaranteed Notes – High Yield Notes (HYN) Application of Option Volatility Trading (2) Equity Derivative Structured Products Bond Equity Derivatives + = Structure: Bull/Bear/Range Underlying: Stock/Basket/Index Return: Coupon/Redemption (fixed or dependent on underlying performance) Equity Linked Note

Reference (apr02) 19 n Considerations:U/L, participation, protected portion n Structure:Investor + note + options n Pricing:participation = (unprotected portion + interest) / option value Types:range / bull / bear Principle Guaranteed Notes Equity Derivative Structured Products

Reference (apr02) 20 Equity Derivative Structured Products U/Ls: TSMC Tenor: 1/2 year on notes Options: + 100~110 call spread Notes: + zero coupon note Protection: 97% Issue price: 100% Participation: 100% of the appreciation of U/L on maturity Redemption: on maturity, if * appreciation of U/L < 100%, redemption will be 97% * 100% <= appreciation of U/L < 110%, redemption will be 97% + appreciation of U/L * appreciation of U/L >= 110%, redemption will be 97% + 10% Principle Guaranteed Notes — Example 1

Reference (apr02) 21 Equity Derivative Structured Products U/Ls: TSMC Tenor: 1/2 year on notes Options: + 100~110 call spread Notes: + zero coupon note Protection: 94% Issue price: 100% Participation: 100% of the appreciation of U/L on maturity Redemption: on maturity, if * appreciation of U/L < 100%, redemption will be 94% * 100% <= appreciation of U/L < 110%, redemption will be 94% + appreciation of U/L * appreciation of U/L >= 110%, redemption will be 94% + 10% The difference in protection rate above indicates a different implied volatility in the embedded call options Principle Guaranteed Notes — Example 2

Reference (apr02) 22 Equity Derivative Structured Products Considerations:U/L, issue price, annual yield Structure:Investor + note - options Pricing:issue price = PV(par) - option value Types:bull / bear / range High Yield Notes

Reference (apr02) 23 Equity Derivative Structured Products U/Ls:TSMC at $78.64 Tenor:60 days on notes Options: - 90% put, strike at $ Notes:+ zero coupon note Issue price:98% of par Ann. Yield:12.2% Redemption: on maturity, if * U/L close >= 90%, redemption will be at 100% of par * U/L close < 90%, redemption will be the stock price on maturity / $70.78 High Yield Notes — Example

Reference (apr02) 24 Summary Making profit without taking directional view but view on market volatility through delta-neutral strategy. (Provided that short selling facility on the underlying is possible) Volatility trading concept and application Hedging option portfolio –volatility risk (Gamma and Vega risk) –liquidity risk (the discontinuous movement of stock price) Equity derivatives structured product –combining equity options and fixed income securities whose feature depends on options premium paid/ sold