Option Basics

[sails]

...Your question appears deceptively simple, but underpinning answers to this question is a labyrinth of complexity (kind of like the iceberg below the water)...

So true, Mag! I have attempted to answer this a couple of times, however, time constraints (due to the early arrival of a baby granddaughter on Sun night) plus realising an answer was going to be lengthy, the replies never got completed.

Just quick speed reads of ASF is about all I have time for now - will hopefully be able to add to the thread when more time becomes available.

 

[jayhfd]

How do i actually exercise company options? (i know this is an eto thread... but why not have it all in one spot?)

Do I have to call the company? Or do I do it somehow by calling up my broker? I'm with comsec.

Thanks

 

[wayneL]

This is the interesting area for myself.
Should you therefore calculate the two volatilities, the current volatility, the one you are going to pay for today, and the historical volatility to illustrate the volatility *spread*.

My view on this is that it should not be viewed as a "spread" per se'. Rather, I use historical volatility as a "tool" , along with my best "guess" of future volatility, to evaluate the the current (implied) volatility as to whether the price is "fair" and where the greek risks are.

Using this assesment then determines which strategy I think will best fit.

for e.g. - If I'm bullish and expecting an immediate strong move, IV is in the low part of its range (or I think it's underpriced) and I am expecting an increase in volatility, there is no better strategy than a straight out bought call.

However if IV's are very high and there is a risk of IV crush, the straight out bought call is p###ing into the wind. I might go for a vertical/ratio spread instead and try to benefit from the IV crush.

Does the volatility crush comes into effect if [as in your example] the common has been trending up, then corrects, falling for say three days, resulting in an increase in volatility [and increased possibly against historical volatility] then, with the end of the reversal, and the common trading higher, the option reverts to a lower implied volatility?

This is certainly true in most instances with index options, but not always true with equity options, not in the normal market swings anyway. Not often enough to use price *direction* as a volatility predictor.

 

[ducati916]

enzo

My view on this is that it should not be viewed as a "spread" per se'. Rather, I use historical volatility as a "tool" , along with my best "guess" of future volatility, to evaluate the the current (implied) volatility as to whether the price is "fair" and where the greek risks are.

Spread, was probably the wrong word, implying a value spread. I am valuing them on historical volatility & current volatility, implied volatility is the future and an outright guess.

Assuming for the example, historical volatility is lower than current volatility, then the ask price for any given option *should* be higher, as all the other greeks key their values from vega [past, present, future] The historical volatility seems to make itself seen in the spread price on the bid.

Therefore the greater the deviation in current volatility from historical volatility, the greater in many [but not all] Option bid/ask spreads. These can [and do] change with tomorrows, or next weeks volatility [future]

Therefore knowns;
*historical volatility
*current volatility

Unknowns;
*future volatility

Can we price future volatility?
Which comes round the houses in a long and roundabout way to the Medical company trade, and the litigation. The future volatility changed quite dramatically with a gap in the shareprice, thus all the greeks changed from the initial values.

This risk, was actually quite elegantly managed via the ratio, calendar, vertical + some common hedging. However, quite a mouthful, never mind actually putting it on.

Hence returning to the valuing on the day of purchase [current volatility] as if you overpay, you will always be on the backfoot in regards to future volatility if it does the unexpected, which must be assumed to be 100%.

If on the other hand, current volatility is underpriced, or fairly priced, you start on level ground with the MM, and can better manage your risk which = future volatility.

jog on
d998

 

[ducati916]

enzo

Just watching the prices currently of ticker ANF, and the common that was trading yesterday at $66.91 is today trading @ $68.51

Option greeks @ $66.91 on a Call Price = $0.40 [ask] which was Fair Value.
*delta 8.8%
*gamma 1.5%
*vega 0.047
*theta -0.014
*rho 0.010

Option greeks @ $68.51 on same Call Price = $0.25 [bid] $0.30 [ask] while Fair Value as calculated should be [Ask] $0.57
*delta 11.4%
*gamma 1.7%
*vega 0.057
*theta -0.017
*rho 0.013

So in your opinion, what exactly do you think is occurring here?

jog on
d998

 

[wayneL]

enzo

Just watching the prices currently of ticker ANF, and the common that was trading yesterday at $66.91 is today trading @ $68.51

Option greeks @ $66.91 on a Call Price = $0.40 [ask] which was Fair Value.
*delta 8.8%
*gamma 1.5%
*vega 0.047
*theta -0.014
*rho 0.010

Option greeks @ $68.51 on same Call Price = $0.25 [bid] $0.30 [ask] while Fair Value as calculated should be [Ask] $0.57
*delta 11.4%
*gamma 1.7%
*vega 0.057
*theta -0.017
*rho 0.013

So in your opinion, what exactly do you think is occurring here?

jog on
d998

what strike and expiry?

Meanwhile here is the vol chart for ANF

http://cboe.ivolatility.com/nchart....,R*1,period*12,all*4,schema*options_big&2=x:1

 

[ducati916]

enzo

Strike $85 Expiry February 17 2007

jog on
d998

 

[ducati916]

enzo

Found this on another thread that you populate;

An options price yeilds an "implied volatility", and not the other way around. People often say that one option has a higher premium because the IV is higher (ceteris paribus). This is backwards. The IV is higher because the premium under the same conditions is higher. That is why it is called "implied" volatility. It is what the future volatility must be (given the time left till expiry) to justify the current market price of a given option.

Current market sentiment determines a given option's value and the IV is the result. The price of the underlying and time till expiry are not debatable, they are fact. Thus to justify a higher market price you also need to "imply" a higher volatility, or greater chance that the option will expiry in the money.

Quite straight forward really, embarrassingly so, but solves my little problem quite nicely......now I can identify *potentially undervalued options*in a very logical manner.

jog on
d998

 

[Magdoran]

Mag's baby!



This is the interesting area for myself.
Should you therefore calculate the two volatilities, the current volatility, the one you are going to pay for today, and the historical volatility to illustrate the volatility *spread*.

Does the volatility crush comes into effect if [as in your example] the common has been trending up, then corrects, falling for say three days, resulting in an increase in volatility [and increased possibly against historical volatility] then, with the end of the reversal, and the common trading higher, the option reverts to a lower implied volatility?

Interested in your response.
jog on
d998

Hello Duc,


Firstly, I tend to focus on IV (implied volatility) over HV (Historical Volatility – or SV – Statistical volatility).

HV only gives you an idea of how the underlying has moved in the past, and is backward looking. It is really a study in statistical standard deviation, and gives you a history of how volatile the stock has been in the past, but only gives a suggestion on how it might react in the future based on your analysis. Of course some volatile stocks can consolidate for long periods of time, then behave in a very volatile fashion in breakouts.

Whereas IV is about what the market is factoring into the future, or how the supply and demand is shaping up both from the market maker perspective (widening spreads, and shifting them to where they think they can extract better margins), and from options market participants (if an institution wants to hedge or foreshadow a move into a stock, they may buy or sell up large quantities of a strike or strikes either in a concentrated time frame, or methodically over time – this can push IV around a lot - up or down, depending on the strategy employed).

This is where good T/A in measuring probabilities is important to trading options in my opinion. If you can measure the likely length of a consolidation, or recognise when a strong move is likely, you can enter with lower volatility for a single option entry, and take advantage later at exit of higher volatility -usually for puts, or at least not suffer much (if at all) volatility crush with calls.

I tend to look at the IV mainly, and consider the range in a time frame, but in context with what the underlying was doing at the time. Generally volatility tends to decline in a gently sustained bullish move, or in benign consolidations, and increase on strong moves, but usually to the downside. Other factors such as potential news items (anticipated announcements, earnings, or media/world events) may effect supply and demand too.

Hence looking at a range of strikes is important to see if there are skews. Sometimes going a but further out of the money is cheaper because an institution is buying the ATM or slightly OTM strike, pushing the price up, while someone may be doing a spread, and selling the next strike up (scenario is someone attempting a bull call spread), hence you can benefit from a good price in the next strike up if going long a call for example.

This is assuming volatility was low for the IV range in your specified timeframe, and you project a small drop at worst (say the range was 20-30 IV, and IV is 22 - probability may be that it would fall to 18 at worst – but this is contextual, hence studying the IV in line with the way the underlying has moved. Hence developing the capacity to estimate and forecast/project possible IV scenarios depending on a range of T/A possibilities is an advantage in my opinion.

HV only tells you what the range of volatility in the underlying was in the past. IV is about what the market is demanding for premium now based on the market makers and market participant’s actual bids now.

Hence I agree with Wayne that you are making your best probability “guess” as to what IV might look like in the future based on your analysis of a range of possible outcomes. I also agree with his view on selecting the right strategy, high IV conditions sometimes works better with spreads to mitigate IV crush risk.

Also you can wait for IV to come back, and enter later, even if the stock is moving in your direction (but hopefully not too fast). A lot depends on if you are trading OTM, ATM or ITM, and how far out in time. If ITM, the deeper you go, the more intrinsic value has a bearing, but your exposure is much higher, and your risk to reward reduces, where profits for OTM plays if correct can be much higher, but theta decay and spread risk is higher too.

So learning to assess wether the market maker is jacking the price up temporarily to pad out their margin when they expect demand to go up (or down for that matter – IV up for buying demand up, IV down for selling increase as people exit on stop for instance – both call s and puts) can greatly reduce risk and augment profit.


Hope that helps Duc.



Regards


Magdoran

 

[Magdoran]

So true, Mag! I have attempted to answer this a couple of times, however, time constraints (due to the early arrival of a baby granddaughter on Sun night) plus realising an answer was going to be lengthy, the replies never got completed.

Just quick speed reads of ASF is about all I have time for now - will hopefully be able to add to the thread when more time becomes available.

Hello Margaret!


I can relate entirely, I’ve been extremely busy too. What a bonanza of a market it’s been!

Look forward to reading your comments when you get time to finish them. I had a burst recently and just hammered these out…

Hope you’re well!


Regards,


Magdoran

 

[Magdoran]

enzo

Found this on another thread that you populate;



Quite straight forward really, embarrassingly so, but solves my little problem quite nicely......now I can identify *potentially undervalued options*in a very logical manner.

jog on
d998

Yup, that’s about the way I look at it too, subtle difference in mindset, but yields quite a different way of looking at the game.


Mag

 

[Lismore]

Hey Guys

Thanks for the responses.
Am still in the learning/paper trading stage so have plenty to learn.

Cheers

 

[wayneL]

An options price yeilds an "implied volatility", and not the other way around. People often say that one option has a higher premium because the IV is higher (ceteris paribus). This is backwards. The IV is higher because the premium under the same conditions is higher. That is why it is called "implied" volatility. It is what the future volatility must be (given the time left till expiry) to justify the current market price of a given option.

Current market sentiment determines a given option's value and the IV is the result. The price of the underlying and time till expiry are not debatable, they are fact. Thus to justify a higher market price you also need to "imply" a higher volatility, or greater chance that the option will expiry in the money.

For us at the retail end of the spectrum, this is most certainly true, and it is most useful for us to look at pricing this way, to determine relative under/overvalue.

Therefore the BSOPM (as proxy for whatever model):

Input ===> Share price, strike, expiry, risk free rate, dividend, Volatility
Output ===> Option price

Becomes:

Input ===> Share price, strike, expiry, risk free rate, dividend, Option Price
Output ===> Implied Volatility

I would love to find out if someone, somewhere in the trading universe (initially at least) inputs volatility to get the output price.

MM's I have listened to say no, that outside bids/asks determine the vols. It seems like a bit of a chicken or egg thing to me.

I suppose it matters not, as far as we retail traders are concerned.

 

[wayneL]

enzo

Just watching the prices currently of ticker ANF, and the common that was trading yesterday at $66.91 is today trading @ $68.51

Option greeks @ $66.91 on a Call Price = $0.40 [ask] which was Fair Value.
*delta 8.8%
*gamma 1.5%
*vega 0.047
*theta -0.014
*rho 0.010

Option greeks @ $68.51 on same Call Price = $0.25 [bid] $0.30 [ask] while Fair Value as calculated should be [Ask] $0.57
*delta 11.4%
*gamma 1.7%
*vega 0.057
*theta -0.017
*rho 0.013

So in your opinion, what exactly do you think is occurring here?

jog on
d998

Can't be too sure without live prices and vols in front of me, but it seems to be a simple case of falling IV. If you have a look st the IV cahrt ling I posted above, IV has been falling the last few days.

Chart below is IV/SV over the last month

 

[wayneL]

Hey Guys

Thanks for the responses.
Am still in the learning/paper trading stage so have plenty to learn.

Cheers

No worries,

Do post as often as possible

 

[Magdoran]

Mag's baby!



This is the interesting area for myself.
Should you therefore calculate the two volatilities, the current volatility, the one you are going to pay for today, and the historical volatility to illustrate the volatility *spread*.

Does the volatility crush comes into effect if [as in your example] the common has been trending up, then corrects, falling for say three days, resulting in an increase in volatility [and increased possibly against historical volatility] then, with the end of the reversal, and the common trading higher, the option reverts to a lower implied volatility?

Interested in your response.
jog on
d998

Hello Duc,


I just wanted to flesh out some observations about how the options market trades in Australia in addition to my broader comment about IV and HV.

Volatility crush can be deadly when long a call, probably more so for positions entered ATM, then OTM, and to some extent ITM (but this can vary a lot depending on how deep ITM you enter).

Sure, you may see a bullish stock rally up, then pull back sharply in a counter trend, and then resume the bullish trend after 1-4 counter trend days. With sharp pull backs, the IV can swing up substantially increasing the premium in long calls.

Interestingly, often it is the ATM, and slightly above and below calls (time to expiry is also a factor) in this case that often spike up in value as IV swings up in a pull back (not always though).

What often happens is a stock pulls back after a bullish drive, somtimes up to half the range of the last drive more or less, then reverses and continue the next bullish leg up.

Some stock traders buy into this kind of pull back - the really good ones get good at picking their entry near the pivot low, and aim to enter a share position as near to the pivot as possible.

An options trader has a more difficult task, and may also have a good technical skill here, but there is an added layer of consideration understanding IV in the timing of a straight long call entry. This includes factoring all the relevant Greeks including IV in terms of anticipated ranges of direction, magnitude and time.

Sometimes a good options player can get set at a better entry price in the option they have identified with the best risk to reward characteristics balanced with probability for success depending on their overall system choices:

(For example, some traders look for 30% correct positions, but look for positive expectancy from a high enough percentage of outlier winners to derive an overall profitable system. Others may look for higher percentage correct trades – maybe 50% or more, but with less risk, and lower rewards on winning trades than the more risky outlier system, but aim to make a profit from having a percentage edge biased to the winning trades).

Hence, on the reversal day the IV may spike well up augmenting the premium significantly. One choice is to consider a spread – bull puts, bull calls, ratio back spread if expecting a strong move and there is a sufficient skew, or even some diagonal spreads depending on your technical outlook. If considering a long call on the other hand, it may pay to wait 1-4 days for IV to drop to an acceptable level. If the underlying shoots up 2 days, then crawls for another 2 days with inside days, or slight pull back days, you may find the price of the desired option actually falls below the available entry price on the reversal day.

So yes Duc, IV crush can happen quite quickly. Sometimes it pays to sell this in a spread (especially if you can get a good skew in our favour and make IV work for you!).

Variables involved are the strike price (ATM, OTM, ITM) and expiry chosen (current month, one month out, 2 months out etc), and the duration of the trade. For shorter term trades, the entry day may be the next one after the reversal day for instance, while longer trades, you may get a better entry on the next pull back, and maybe a day or two after that – this requires experience in both T/A and options trading to evaluate – hence it is in a way an art.

Specifically dealing with straight calls, if the trader’s view is that the underlying is likely to scream up, then a consideration may be to wear the volatility and accept the crush, or maybe move more to ATM to ITM positions in the current month for short sharp moves – although a good OTM position may have the best risk to reward parameters for really big moves in short time frames – there are a lot of variables to consider here, hence having a good modelling tool is vital in my opinion. But this is highly risky, and not the way I tend to trade. I prefer a bit more time if possible in the option, looking for more than 30 days time left in the option for when I exit – but this is a personal preference.

I found that trading the current month was dangerous when I got it wrong, and didn’t have the time to get it right, even when my T/A was right in the long term, the theta decay can really hurt short term positions, hence looking for more time although it reduces the percentage returns in risk to reward terms, it also really reduces the losses when you get it wrong, or more importantly allows you to hang through temporary moves against you (counter trends) long enough to reap profits when the main trend resumes (but you have to know enough about the way markets trend to do this). This presumes a longer term approach, where a trade may last 2 weeks, a month, or even 3 months.

Please note that I’m focussing on bullish plays here with straight calls. This is just one approach, since both Duc and Lismore seemed to focus on this strategy. But please be aware that playing straight puts works almost in reverse to playing straight calls, since the IV tends to fall on a bullish counter trend to a bearish trend. But this is hopefully food for thought for straight options plays – there is a lot just to this, let alone dealing with spread characteristics.


Regards


Magdoran

P.S. Glad this helped Lismore – do read through the various threads on this site on options, you can learn a lot here. Especially look up all the threads Wayne and Margaret have commented on, and others like Mofra amongst others who have options knowledge. I suspect many of your key questions may be answered in these discourses.

 

[ducati916]

enzo & Mag's

Thank's guy's.
First off IV crush on Call Options is counter-intuitive, and thus initially rather tended to spoil my valuations, which upset me tremendously. That they are intuitive with Put's mollified me slightly.

As per usual, it is simply working with the numbers [values] or greeks enough that you can read the story that they are telling, and more importantly, when the story is a barefaced fabrication.

I would love to find out if someone, somewhere in the trading universe (initially at least) inputs volatility to get the output price.

This is exactly what I now calculate, from having my mini-epiphany, for my style, where I am trading on valuations, this is the critical step. So simple, yet so easy to overlook.

MM's I have listened to say no, that outside bids/asks determine the vols. It seems like a bit of a chicken or egg thing to me.

I believe them.
Simply because there are some howlers out there, both on overvaluation & undervaluation. In a completely different calculation, market inefficiency is as rife in the Options universe, as it is in the Stock universe.

Price action, as defined within the stockmarket, is responsible for market inefficiency, the exact same phenomena is present in the Options market, driven by price action............stunning!

jog on
d998

 

[SevenFX]

Hi Wayne,

If possible this link may help new members if included in your first post, b4 they start reading the thread...perhaps mods can add it...????

Just about to start reading this thread, but thought to post these links for anyone that wants to watch this Little video'(s) of option basics, including many other videos on warrants, sharemarket, etc

Only thing is you need to be registered (simple process) with the ASX site...

Part of their free education when registered.

http://www.asx.com.au/programs/vignettes/lesson4.html

I sure I will have some questions for you later and thanks for starting this thread.

Cheers
SevenFX

 

[potato]

hey guys
in regards to the asx, whats happens when an option expires ITM? does it expire worthless if u dont close it out, or is the intrinsic value of the option settled automatically?

 

[wayneL]

hey guys
in regards to the asx, whats happens when an option expires ITM? does it expire worthless if u dont close it out, or is the intrinsic value of the option settled automatically?

I'm not sure what happens on the ASX, but in the US, if the option is in the money by a certain amount (i.e. 25c) the option is automatically exercised, unless you specify for it not to be. If no exercise, you will lose the intrinsic value of the option. So be sure to know the mechanics of this.

As a rule, I almost always close out long options before expiry, unless I particularly want the shares (almost never). This is the most efficient way to capture intrinsic value, as once the option is exercised, you are exposed to unlimited risk via the share.

Only cash settled options (such as index options) will be settled in cash on expiry.