The Option Pit Method Option Pit Option Pit Boot Camp The Option Pit Method For trading options

Option Boot Camp- The Option Pit Method -The Option Pit method uses -Position Structure -Efficient use of Capital -Risk Management -Structure positions that have “edge” but keep the risk relatively low. -To do that traders need to know the fundamentals to identify market conditions

The Option Pit Method “The volatility is in the toilet.” - Mark Sebastian numerous times on Bloomberg News “If you think education is expensive, try ignorance.” ― Derek Bok, former Harvard PresidentDerek Bok

Option Boot Camp- What you will learn What makes an option move? Intent! – Inputs and Greeks Understanding Volatility Conditions Trade selection We will cover spreads, collars and butterflies Use the Greeks to manage your book - Intro to risk management

Boot Camp I- What you will learn The Option Pit Input Circle The Option Model The Greeks – Delta, Gamma, Theta, Vega

The Option Pit Input Circle Moneyness - Which Strike? Time to expiration – How Far? Time Decay - positive or negative decay Volatility – How much does the underlying move? Direction of the Underlying - up, down or nowhere fast

The Option Pit Input Circle What makes an option move?

Moneyness- Which Strike Are the options big dollars or small dollars? As the strike price goes from lower to higher – Calls will go from ITM to OTM – Puts will go from OTM to ITM The more ITM the strike price is, the more it is sensitive to changes in price The further out in time we go, the more the strikes act alike The higher the volatility, the more the strikes act alike The more ITM the option is, the more cost of carry issues come into play

Direction of the Underlying- Price Price of the underlying is one of the inputs that most traders get – When price goes up, calls gain value The lower the strike price, the more value it will gain from price The further out in time one owns the option, the less sensitive to price the options will be The higher volatility of the underlying, the less sensitive to price the option will be

Direction of the Underlying- Price When price goes down, puts gain value The higher the strike price, the more value it will gain from price The further out in time one owns the option, the less sensitive to price the options will be The higher volatility of the underlying, the less sensitive to price the option will be

Time to Expiration- Expiration Date Time is money! – Small price changes will have little effect on the price of the option – Calls and put at all strikes will all head towards being ATM options – Options become more sensitive to changes in a stock’s volatility – More time, more issues with cost of carry (dividends)

Time Decay- Long or Short Options Does the position lose value every day just by showing up or does it make you money? -That is time decay Long options have negative time decay Short option have positive time decay

Volatility How much does the underlying move? – That is volatility Of all the inputs in the model, this is the only one we really don’t know – Interestingly enough, the model is trying to use ‘forward volatility’ – Ends up using implied volatility As volatility increases, the value of all options increases – Buying insurance before or after a hurricane

Add the inputs together Once all the inputs are accounted for, investors can start to generate an idea for a position Some of the inputs are easy and some are much harder Look at risk now for the goodies you get versus the risk of the inputs changing

Pricing Model Uses Inputs Volatility Price Time to Expiration Strike Cost of Carry Inputs Theoretical Value

What is a Normal Distribution Assumes stocks have an equal chance of moving up or down at any given time

Variance When a distribution moves within a normal range, it is called a variance A variance represents how much we would expect the data set to vary most of the time We use variances all the time as traders

What is Volatility Volatility is another word for the statistical term variance over a specific range of time – Represents an expected range for a stock or index on an annualized basis regardless of direction A 75 dollar stock that has a volatility of 20% – In a given year, the stock is expected to move 15 dollars OR LESS about 2/3 of the time. – In a given year, the stock expected to move 30 dollars OR LESS 95/100 of the time

Standard Deviation Standard Deviation: annualized volatility over a non-annual period of time volatility*sqrt(days/year) Allows traders to connect annualized into volatility into short periods of time – Allows for use to analyze earnings, events, low and high vol, you name it

Standard Deviation Calculation SPX midday Dec 9 th 2014 – Volatility for the Jan Ord is – Expiration is in 37 days – So.166 x (37/365)sq rt =.052 – 2041 x.052 = $107 for roughly 2/3 of the time

What is Volatility There are 3 kinds of volatility we will talk about: – Historical Volatility – Forward Volatility – Implied Volatility

Forward Volatility How much is a stock moving from RIGHT NOW until EXPIRATION – Impossible to gauge We are trying to be fortune tellers – Can use estimates like volatility charts Involves overnight risk Weekend risk Intraday risk

Historical Volatility How much has the stock moved over the last time period – High-Low Volatility – Intraday Range – Close Close – Open Open 10 day, 20 day, 30 Day, 90 day, 180 day – I like 20 day because it is has some noise – Tracks 30 day IV

Implied Volatility We will dig into this more, but: – Implied Volatility is actually an OUTPUT Because it is an OUTPUT, and we do not know what the stock's volatility is, Implied Vol is actually an output Garbage in, Garbage out

Implied Volatility Issues with implied volatility: – Because of market fear of a major increase in forward volatility, option implied volatility is often too high relative to what ends up being the calculated forward volatility (we will see this in the term structure) – Typically believed to be about 3-4% too high – Because an instrument may have many strike prices, hedges or speculations can still be wrong – The BID-ASK spread in options can throw off IV

Reversion In any given year, an event can cause a security to have an “outlier” volatility But, over time, volatility of any asset will tend to mean revert – This means that it will hover around its average – This applies to all types of volatility that can be measured HV will revert to its mean IV will revert to its mean FV will overtime BE the mean

Understanding risk in terms of inputs The GREEKS ARE AN OUTPUT of a pricing model not an input As the 5 factors change, so do the Greeks The Big Greeks Are: – Delta – Gamma – Vega – Theta

Easy Greeks

Using the Greeks as a Risk Management Tool

How to get to P/L Option Pit FLOW CHART

Easy Greeks- Delta

The way an option’s price will move with the underlying price, sometimes called correlation A Positive Delta will move just like stock – when the underlying rallies, the option MAKES money A Negative Delta will move OPPOSITE of a stock – When the underlying rallies, the option will LOSE money

3 Definitions Change in the option price with a $1 move in the underlying Delta is a hedge ratio – how many shares of a lot of stock that particular option hedges A Loose percentage chance an option finishes ITM Delta is a option’s sensitivity to a stock’s PRICE DIRECTIONAL movement

Easy Greeks Delta Delta has a range of to – Options with negative deltas negatively correlate to the underlying – Options with positive deltas will positively correlate with the underlying – The closer the delta is to 1 or -1 the more it correlates positively or negatively with movement in the underlying

Calls and Puts Calls have a positive delta – Buying a call is going long delta – Selling a call is going short delta Puts have a negative delta – Buying a put is going short delta – Selling a put is going long delta But different positions!

Using the Greeks as a Risk Management Tool

Easy Greeks- Gamma

Gamma The simplest definition of gamma is: it is how delta changes as the underlying price changes – The measure is how much delta will change with a 1 point move in the underlying It is the options sensitivity to a stock’s MOVEMENT regardless of direction – Called REALIZED Volatility

Gamma If a trader buys calls or puts, the trader is long gamma If the trader sells calls or sells puts, the trader is short gamma – The sign of delta and the sign of gamma have NOTHING to do with each other – A trader can be long delta and short gamma – A trader can be short delta and long gamma

Gamma Long Gamma – If the position is long gamma as the underlying rallies, the position will increase in delta – If the position is long gamma as the underlying falls, the position will decrease in delta Short Gamma – If the position is short gamma as the underlying rallies, the position will decrease in delta – If the position is short gamma as the underlying falls, the position will increase in delta

Easy Greeks- Theta

Theta The simplest definition of theta is: it is the rate at which an option’s time premium or ‘fluff’ is disappearing – How quickly is the ‘insurance value’ heading to 0 The technical definition is the sensitivity of the option to the passage of time Theta measures TIME RISK

What is Time Decay Time Decay is the difference between a stocks intrinsic value vs. the stocks extrinsic value EXAMPLE: XYZ is trading 28, the 25 dollar call is trading 5.00 even – Intrinsic Value: 3.00 – Extrinsic Value 2.00 At expiration – Intrinsic Value: 3.00 – Extrinsic Value: 0

Theta A positive theta position will benefit with the passage of time (as time passes position MAKES $$$) A negative theta position will be hurt by the passage of time (as time passes position will lose $$$) Long options have negative theta Short options have positive theta

Using the Greeks as a Risk Management Tool

Easy Greeks - Vega Calm seas or rough seas?

Vega The Vega S.A.T. question: – Delta is to Change in Price as Vega is to: White Castle Sliders Implied Volatility Chevy Camaro IROC-Z Cat Nip Vega is the change in Profit from a 1 point move in implied volatility Vega measures CHANGE in IMPLIED VOLATILTY RISK

Vega A positive (+) Vega position will benefit with an increase in implied volatility A negative (-) Vega position will be hurt by an increase in implied volatility Long options have positive Vega (long juice) Short options have negative Vega (short juice)

Vega If a trader buys calls or puts, the trader is long Vega If the trader sells calls or sells puts, the trader is short Vega There is a trade off protection against IV movement vs. collecting premium – The insurer vs. the insuree Think time line as we go into the 5 factors- 60 days, 30 days, 10 days?

Using the Greeks as a Risk Management Tool

Managing Risk with Greeks Managing Risk is about what the trader Does not know. – First understand how the Greeks balance against each other in one position – How do your positions work together? Let’s walk through some examples

Using the Greeks as a Risk Management Tool Delta- Managing the direction of the position Gamma- Managing the change in delta Vega- Managing the change in volatility Theta- Managing the change in time (dividend)

Summary Inputs move option prices Changing inputs move Greeks Greeks measure risk and profit and loss potential Use the Greeks to take the risk you want

Option Pit Boot Camp 1 Quiz What is the flow of model inputs to generate P/L? Is acceleration a fair way to describe gamma and what is the market factor most closely associated with it? What is positive Theta? Is it free? What is Vega in a position? Please explain.