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.

Options Trading Overview By Steve Chang

Introduction Steve Chang Equity Derivatives Trader at Morgan Stanley

Topics of Discussion Basic on Options Overview on Greeks Volatility Why using options? Impact to TSE Trading Strategies Buy/Sell Greeks Scenario analysis Q & A

Basics on Options Call – give the holder the right to buy the stock by a certain date for certain price Put – give the holder the right to sell the stock by a certain date for certain price Premium - cost of options (call or put) Strike price - the price at which an option contract gives the holder the right to buy/sell

Basics on Options Expiration date - final date options can be exercised Volatility – risk factor of an option that determines the premium (40 vol = 2.5% intraday gap) American options - options can be exercised before expiry European options - options can only be exercised at expiry

Overview on Greeks Delta – rate of change of option’s price w/ change in underlying asset, usually short dated ATM call/put has ~0.5 delta Gamma - rate of change of delta w/ the change in underlying asset, usually quoted in % term (+$1mn gamma, mkt +3%, +$3mn delta)

Overview on Greeks Kappa (vega) - rate of change of option’s price with change in volatility. Theta – rate of change of option’s price with change in time, the price of gamma/kappa Rho – rate of change of option’s price with change in interest rate

Volatility Higher the vol, higher the premium 2mth 100% call at 40% vol ~ 6.75% (0 div, 1.82% Rfr) 2mth 100% call at 70% vol ~ 11.65% Market implied vol vs. asset vol Implied usually higher than asset (Hang Seng, S&P) Implied vol at 40% -> 2.5% gap risk

Volatility – 2330

Volatility – 1310

Volatility – 2882

Why using Options? Leverage/ gearing effect (like warrants) Reinforce stop-loss concept when buying Income enhance when selling Portfolio hedge for PMs Short access to single stock names (+P, -C) Long access to single stock w/o showing broker identity

Impact to TSE More participation from retails investors Enhance market liquidity with delta hedge Stock lending system needs to be developed Stock lending can increase market liquidity thru long/short pair trading Limit-up/limit-down 7% structure

Trading Strategies Buy downside put as insurance when long stocks Sell upside call to collect premium when upside is limited Buy call spread expecting limited upside Buy put spread expecting limited downside Buy strangle or straddle expecting volatility ahead Synthetic short – buy put sell call Most PMs buy options not sell

Trading Strategies Buy call option Expecting more upside

Trading Strategies Sell put option Expecting limited downside

Trading Strategies Buy call spread When? Expecting more upside, reduce prem by giving up some upside For Example: you buy 100/120 call spread – buy 100% call, sell 120% call Max upside = 120 – 100 – prem(%) Max downside = premium you paid Sell call spread – vice versa

Trading Strategies Buy put spread When? Expecting more down, reduce premium by giving up some downside protection For example: Buy 100/90 put spread – buy 100% put, sell 90% put Max upside = 100 – 90 – prem(%) Max downside = prem you paid Sell put spread – vice versa

Trading Strategies Buy Straddle Buy both ATM call and put Max gain: unlimited Max loss: time decay (theta) Buy gamma and kappa, pay theta Short dated straddle – buy more gamma Long dated straddle – buy more kappa Sell straddle – vice versa

Trading Strategies Buy strangle Buy both OTM call and put Max gain: unlimited Max loss: time decay, theta You buy gamma and kappa, earn theta Short dated strangle – buy more gamma Long dated strangle – buy more kappa Diversify your risk comparing to straddle and cheaper Long straddle – vice versa

Buy/sell Greeks Buy delta Buy spot (ie, future or stocks) Buy call Sell put Sell delta – vice versa

Buy/sell Greeks Buy gamma Buy call or put Short dated options give you more gamma ATM options give you more gamma Sell gamma – vice versa

Buy/sell Greeks Buy Kappa Buy call or put Long dated options give you more kappa ATM options give you more kappa Sell kappa – vice versa

Buy/sell Greeks Long theta (receive time decay) Sell call or put Short dated options give you more theta (in the expense of short more gamma) ATM options give you more theta Sell theta – vice versa Buy/sell Rho – N/A for Taiwan, usually hedged by eurodollar futures or swaps

Scenario Analysis If you have $1mn to buy a stock ($100). Option vs. stock strategy? (assume no funding cost) Buy 10k at $100, +30% after 2mth, PnL = $300k If you buy 10k of 2mth $100 strike call paying 7% or $70k (40%vol) If stock +30% in 2mth, then you have the right to buy 10k shares at $100 which will give you the PnL of $230k ($300k – $70k) …also less funding. Max loss using option is $70k, but loss is unlimited buying stocks If you spend $1mn on option, PnL = $3.3mn = $1mn/7%*(30%-7%)

Scenario Analysis If you are long $2mn gamma on a stock, then stocks –28% thru 4 days of limit-down…what would be your payout? $2mn*28 = 56mn you are short US$28mn which you may cover @28% discount. PnL impact: 28mn/2*28%=$7.84mn

Q & A