Trading Options in Turbulent Markets E-Book

Larry Shover

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Bloomberg Professional
• Sprache: Englisch

Seitenzahl: 442

Veröffentlichungsjahr: 2012

Beschreibung

Top options expert Larry Shover returns to discuss how to interpret, and profit from, market volatility Trading Options in Turbulent Markets, Second Edition skillfully explains the intricacies of options volatility and shows you how to use options to cope, and profit from, market turbulence. Throughout this new edition, options expert Larry Shover reveals how to use historical volatility to predict future volatility for a security and addresses how you can utilize that knowledge to make better trading decisions. Along the way, he also defines the so-called Greeks--delta, vega, theta, and gamma--and explains what drives their values and their relationship to historic and implied volatility. Shover then provides effective strategies for trading options contracts in uncertain times, addressing the decision-making process and how to trade objectively in the face of unpredictable and irrational market moves. * Includes a new chapter of the VIX, more advanced material on volatility suitable for institutional or intermediate options trader, and additional volatility-based strategies * Answers complex questions such as: How does a trader know when to tolerate risk and How does a successful trader respond to adversity? * Provides a different perspective on a variety of options strategies, including covered calls, naked and married puts, collars, straddles, vertical spreads, calendar spreads, butterflies, condors, and more As volatility becomes a greater focus of traders and investors, Trading Options in Turbulent Markets, Second Edition will become an important resource for in-depth insights, practical advice, and profitable strategies.

Leseprobe

Contents

Preface

Acknowledgments

Introduction

Part I: Understanding the Relationship between Market Turbulence and Option Volatility

Chapter 1: Managing Risk and Uncertainty with Options

What Is Risk?

What Is Uncertainty?

Seven Lessons Learned from Market Volatility

Understanding Derivatives

The Six Benefits of Options

Chapter 2: Making Sense of Volatility in Options Trading

Volatility as an Asset Class

Analyzing Volatility with Implied Volatility

What Does Implied Volatility Reveal?

Making Trading Decisions Based on the Disparity between Historical and Implied Volatility

Appreciating Volatility for All It Is Worth

How Volatility Really Works on the Trading Floor

Volatility and Uncertainty: Lessons for the Irrational Option Trader

Varieties of Option Volatility Trading

Chapter 3: Working with Volatility to Make Investment Decisions

On Predicting the Future

Starting with Historical Volatility

Implied Volatility

Why Do Volatilities Increase as Equities Fall?

Implied versus Historical Volatility

Justification for the Disparity between Historical and Implied Volatility

Chapter 4: Volatility Skew: Smile or Smirk?

Considering Some Examples

A Primer on Random Walk and Normal Distribution

Dealing with the Higher Moments of the Normal Distribution

Skew Is High, Skew Is Low. So What?

Does a “Flat” or “Steep” Skew Predict the Future?

A Fair Warning about Thinking about Skew too Much

Chapter 5: Fixated on Volatility and the VIX

What We (Think) We Know

Definitions of VIX

Grasping the VIX Index

VIX—A (Very) Brief History

VIX: Calculation and Interpretation with a Simple Calculator

Important Insights on the VIX Index

What Does the VIX Tell Us?

VIX and Perhaps the Biggest Misnomer of All!

Part II: Understanding Option Volatility and Its Relationship to Option Greeks, Personal Decision Making, and Odds Creation

Chapter 6: Extreme Volatility and Option Delta

The Misnomer of Delta and Probability of Exercise

Delta Defined

The Relationship Between Volatility and Delta

Higher Volatility and Delta

Lower Volatility and Delta

Delta, Time, and Volatility

Delta, Position Delta, Volatility, and the Professional Trader

Chapter 7: Smoke and Mirrors: Managing Gamma through Volatile Markets

Gamma and Volatility

Managing Positive Gamma during a High-Volatility Environment

The Bad News: There’s Always More than Meets the Eye

Practical Considerations for Managing Long Gamma in a High-Volatility Environment

Managing Negative Gamma in a High-Volatility Environment

Practical Considerations of Negative Gamma in High Volatility

Gamma and Volatility with Respect to Time Structure

Summary

Chapter 8: Price Explosion: Volatility and Option Vega

The Relationship between Implied Volatility and Vega

Implied Volatility: Price Analogy

Option Vega and Time

Option Vega and Its Greek Cousins

Option Vega Implications

Don’t Underestimate the Relationship between Volatility and Option Vega

Volatility and Vega Insensitivity

Important Concepts When Applying Option Vega in a Volatile Marketplace

Summary

Chapter 9: Sand in the Hourglass: Volatility and Option Theta

Balancing Time Decay with Volatility: Mistakes Traders Make

Volatility and Theta: What Every Investor Needs to Know

Chapter 10: The Nuances of Volatility

The Complication Surrounding Vega Risk in an Option Position

Implied Volatility Skew + Term Structure = Volatility Surface

Implied Volatility Term Structure

Did You Know Your Volatility Has Volatility?

The Normal Value of Volatility

Part III: Ten Proven Strategies to Employ in Uncertain Times

Chapter 11: Preparing for Trading Using Volatility Strategies

The Elements of a Sound Trading Decision

Developing an Approach to Options Trading

The Mind of a Successful Trader

Decision Making, Options versus Everything Else

Chapter 12: The Buy-Write, or the Covered Call

The Buy-Write (Covered Call) Defined

An Example of the Covered Call Strategy

The Theory and Reality of the Covered Call

Covered Call Writing and Implied Volatility

Implied Volatility in Practice

Managing Contracts in a Time of High Volatility or a Falling Market

Effective Call Writing in a Volatile Market

Chapter 13: Covering the Naked Put

Contemplating the Cash-Secured Put

Utilizing the Cash-Secured Put in a High-Volatility Environment

Cash-Secured Put and Volatility: Risks and Consequences

Income Strategy: Volatility as an Asset Class and Cash-Secured Puts

Position Management

Chapter 14: The Married Put: Protecting Your Profit

Volatility, Downside Risk, and the Case for Portfolio Insurance

Why Buy High Volatility?

The Married Put

How and When to Use a Married Put

Example of When to Use a Married Put

The Married Put: Limiting Loss, Neutralizing Volatility, and Unleashing Upside Potential

Married Put: A Real-Life Illustration

Chapter 15: The Collar: Sleep at Night

Collar Strategy

Types of Collars

Summary

Conclusions on the Collar Strategy

Chapter 16: The Straddle and Strangle: The Risks and Rewards of Volatility-Sensitive Strategies

The Buying or Selling of Premium

Properties of Straddles and Strangles

Comparing Straddles and Strangles

How to Compare Historical and Implied Volatility

The Impact of Correlation and Implied Volatility Skew

An Alternative to the Naked Volatility Sale via the Straddle/Strangle: The Strangle Swap

Chapter 17: The Vertical Spread and Volatility

Introduction to the Vertical Spread

A Trader’s Reasoning for Trading a Vertical Spread

Designing Your Vertical Spread

Vertical Spreads and Greek Exposure

Vertical Spreads as a Pure Volatility Play

Comparing Volatility’s Effect on Vertical Spreads

Summary: Comparing Vertical Spreads and Implied Volatility

Chapter 18: Calendar Spreads: Trading Theta and Vega

Calendar Spreading—Trading Time

Risks and Rewards of the Calendar Spread

A Calendar Spread with a Bullish Expectation

Considerations and Observations for Calendar Spreads and Volatility

Chapter 19: Ratio Spreading: Trading Objectives Tailor Made

How Back Spreads and Ratio Spreads Work

Back Spreads

Ratio Spreads

Greek Values and the Back Spread or Ratio Spread

Configuring and Pricing a Back Spread or Ratio Spread

Reconciling Volatility and the Back Spread or Ratio Spread

Chapter 20: The Butterfly Spread

Setting up a Butterfly

The Butterfly Spread as a Volatility Investment

Greek Values and the Butterfly

Structuring and Pricing a Butterfly

Trading Butterflies in a Volatile Market

Chapter 21: Wingspreads

Capturing Convergence and Divergence

Wingspreads: Risk/Reward

Wingspreads: Sensitivities

Wingspreads and the Greeks

Wingspreads: Various and Sundry Details

The Condor Spread

Conclusion

About the Author

Index

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Cover Design: C. Wallace

Cover Image: Ocean waves © Irina Belousa/iStockphoto

Copyright © 2013 by Larry Shover. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

The First Edition of Trading Options in Turbulent Markets was published by Bloomberg Press in 2010.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Shover, Larry.

Trading options in turbulent markets : master uncertainty through active volatility management / Larry Shover. — 2nd ed.

p. cm.

Includes index.

ISBN 978-1-118-34354-8 (cloth); ISBN 978-1-118-41663-1 (ebk); ISBN 978-1-118-43403-1 (ebk); ISBN 978-1-118-42021-8 (ebk)

1. Options (Finance) 2. Risk management. I. Title.

HG6024.A3S537 2012

332.64’53—dc23

2012038304

To Maribeth, Megan, Tim, & Andy

Preface

Trading Options in Turbulent Markets, Second Edition further reveals how volatility in options trading relates to today’s stormy marketplace and shows you how to manage risk and take advantage of market volatility when investing in derivatives. This book addresses how to use historical volatility to help predict the future value of a security, or the implied volatility, and offers suggestions for dealing with that odd feature of options trading known as skew—in which the options market has, in recent decades, essentially developed its own consciousness and can respond to market conditions that defy all logic. Skew is uncertainty squared, and here, I describe how to work with or around it.

This book also includes proven tools for evaluating options trading decisions: the Greeks—delta, vega, theta, and gamma. We will define the values carefully and describe how each relates to volatility. In addition, you will discover effective strategies for trading options contracts in uncertain times, explore the decision-making process in broad terms, and learn how to become a steel-nerved trader. Along the way, this book answers complex issues such as: How does a trader know when to tolerate risk? How does a successful trader think or respond to adversity? How does a trader lose well?

Trading Options in Turbulent Markets also looks at specific options trading strategies that help you offset risk and reach for profit. These include the covered call, the naked and married puts, collars, straddles, vertical spreads, calendar spreads, butterflies, along with a new chapter on wingspreads. This second edition features a deeper dive into the vastly popular VIX—the fear gauge—along with the uncovering of various volatility terms once reserved for the institutional world that are now becoming more mainstream.

Filled with in-depth insights and practical advice, this important resource explores how to turn turbulent markets into profitable opportunities and reveals why options are the best tool to use in such a difficult endeavor.

Acknowledgments

I would like to begin by saying thank you to the hundreds of brokers, traders, clerks, and exchange personnel with whom I’ve shared both the opportunity and privilege to grow and learn as a trader over the years. Spending countless hours jammed shoulder-to-shoulder with other traders and trading staff produces a bond—a familial link—that transcends both emotions and time. I started in this industry as an 18-year-old boy. Now, looking back, I reflect on the lessons learned, the emotions, the broken dreams, the vast fortunes made and lost, as well as the raging hostility of my fellow traders at times, and the fear. All of this I have collected and filed away. The ink spilt during the writing of this book is the result of this experience, and for that I am most grateful.

A very special thanks to my original editor, Stephen Isaacs, of Bloomberg Press. To date, Stephen’s phone is never far away—he continues to be available to me for anything and everything!

Thanks also to my John Wiley & Sons family! To Kevin Commins and Marty Schecter, both of whom worked vigorously crafting the vision necessary for this second edition; always moving the mountain in the right direction! To Meg Freeborn—a senior development editor that most authors could only hope for. To my senior publicist, Stacy Smith, who took my book quite personally—doing whatever it took to help it become a true evergreen!

A big round of applause to Josh Suckenic of OptionsXpress, who early on appreciated the uniqueness of my book and helped create the vision for this second edition.

Jim Bittman of the Chicago Board Options Exchange and Option Institute is, in my estimation, the industry’s most stimulating and capable instructor on options trading. Jim has written two very successful books and was always very encouraging and supportive of my writing efforts. I’m grateful to have a friend like Jim to emulate.

Curt Zuckert of the CME Group’s Trading Knowledge Center (TKC) regularly greeted me with a smile even though he knew full well that my sole intention was to camp out in his “library,” using it as my personal office (for my personal gain) while researching this second edition. Although I had plenty of places where I could have gone to write, the atmosphere at TKC gave me both hope and inspiration.

Matthew Curtis once again did nothing short of save me from my technical deficits by designing and editing most of the initial charts and graphs. I count myself very fortunate to be able to defer to Matthew, coming to him mostly empty-handed and leaving with a stunning piece of art. Matthew truly saved me from countless failed and frustrated efforts.

A very big thanks to my chief technical writer, Mark Dawson. Mark is not only one of the greatest technical writers in the options field, he also carries with him a sixth sense. Mark had a continuous feeling for where this second edition was heading and kept me swimming in the right direction. When I ran out of ink, Mark was there—he possessed an uncanny ability to keep me focused on the book, its intention, and the audience I was hopefully trying to reach.

Introduction

The United States used to be a good place to make assumptions.

Young men and women were admitted to college without creating marketing videos of themselves and without pledging their teenaged years to an extracurricular cloister. College arrived, and college led to graduation (four years), a cubicle, modest debt, spouse, offspring, real estate, health insurance, trips to Disneyland. Nurses and math teachers did not need resumes. Single-family homes increased in value every year. That’s written in the Bible somewhere. People in their 50s and 60s owned homes that were paid off. If you had been working somewhere for 20 years or more you could safely hide in your office until you turned 65, and at that point, with your golden years ahead, Social Security would be waiting patiently. Forever would Americans buy Kodak film, books at Borders, tools and trousers at Sears. When recession did arrive (the non-Great kind) a company like Circuit City might dally with Chapter 11, but only long enough to get reorganized and draw enough investment capital to return to health. If a developer was stuck with an office tower or apartment project that was still unfinished when economists announced that the downturn had started, the investors pushed to finish the property anyway, and then made an effort to find tenants. Walking away from a property with rebar sticking out of the top was unthinkable. And regardless of the economy, talk of Chapter 11 for icons like General Motors or Bank of America was the province of conspiracy theorists with greasy hair and smudged glasses.

The end of the last century offered engineers writing software in Mumbai and Moscow and Chinese factories that assembled, well, everything. The Internet shook the planet even more than Gutenberg’s invention did more than five centuries earlier. And then the strangely old-fashioned financial panic of 2008 arrived.

The panic has subsided, but the rubble remains:

The venerable United States Postal Service lost a third of its first-class mail volume and started talking of eliminating Saturday delivery for the first time ever as one of the possible cutbacks needed to remain solvent.

Public libraries across the country closed their doors. Firefighters and police officers were laid off. The town of Vallejo, California, filed for bankruptcy.

For 15 years, from 1991 through 2005, Bill Miller, the chairman and chief investment officer of Legg Mason Capital Development, was a superhero for investors. Every year he outperformed the Standard & Poor’s 500, a record unmatched by any competitor, and his fund assets peaked in 2006 at $20 billion. But after the financial crisis started, the old wisdom of the markets no longer worked for him. Miller snapped up bank stocks in the midst of the crisis, expecting them to recover. They didn’t. In 2008, his fund lost more than half of its value, investors headed for the exit, and by the time Miller retired at the end of 2011, his fund’s balance had slid to less than $3 billion.

Greeks responded to talk of austerity with riots, and Italy (a G6 member) trembled close to defaulting on its bonds, as its debt-to-GDP ratios reached levels not seen since the end of World War II. Europeans talked of abandoning the euro—and their southern neighbors—to their fates.

By the end of 2011, the U.S. middle class had watched $8 trillion in home equity vanish. Some 11 million families lost their homes to foreclosure, and throughout 2011 as many as one out of every three homeowners found that their properties were worth as much as 25 percent less than the amount remaining on the mortgage. The term “underwater” had to be invented in 2008 to describe homes that were impossible to refinance and hopeless to sell. By January 2012, U.S. homes had lost, on average, a staggering 40 percent of their value.

The total amount of student loan debt passed the total amount of credit card debt for the first time ever. New graduates struggled with crushing debt burdens even as they faced crippling levels of unemployment. Books and articles for the first time repeatedly questioned whether a college degree was really worth the money.

The Federal Reserve and European Central Bank offered stimulus. Again. Did anyone notice? U.S. Treasury bills remained at least a safe investment, but yields on these bonds fell below 2 percent, and on 30-year bonds, below 4 percent, their lowest rates ever.

Egypt, the largest country in the Middle East, saw mass demonstrations that overturned a dictator. Nothing like that had happened in the nation’s 5,000-year history. Civil war toppled a dictator in Libya and threatened Syria to the north. Mass protests swept the United States, too.

The longest war in U.S. history stumbled on in Afghanistan, though still without clear goals. Relations soured further with a critical ally, Pakistan. Troops were at last withdrawn from Iraq. The U.S. government could not convince the Iraqis to allow it to maintain a military presence, leaving the country—and its oil reserves—to a very uncertain future. Meanwhile, talk of an attack on Iran persisted, prompting the Iranian government to threaten to close the Strait of Hormuz to shipping. This act, easily within the reach of the Iranian military, would lead inevitably to a disastrous spike in oil prices.

The U.S. House of Representatives pushed the U.S. Federal government to within a few weeks of defaulting on its loans and a new global depression in a debate over raising the debt ceiling. For the first time in U.S. history there was discussion of invoking the Fourteenth Amendment to guarantee the government’s solvency; for the first time ever, the government’s credit rating was lowered.

Who wins the Oval Office in 2012? What will Congress—facing approval levels in the single digits—look like? Will the government start to actually work again? And what vision would guide the government if, in fact, it does manage to start producing something in 2013 other than parliamentary maneuvers, stalled appointments, and filibusters?

Welcome to 2012, the Age of Uncertainty. Nobody knows.

The same amount of uncertainty applies to the modern investment community. Computer models still press on, but traders no longer dare to make predictions, because they frequently no longer have any idea what to expect. A trader’s judgment can be reduced to coincidence, or a gamble. Maybe a market swings simply because a single hedge fund completes a large off-floor trade or a major bank starts buying up puts to cover its exposure after issuing warrants. Or one might decide to make a trading decision only when the moon is full, or find that based on past experience, on the third Friday of March or December, if the S&P 500 index has dropped three days in a row, it’s a good time to start buying Swedish municipal bonds. A careful review of these trends six months later might show that they were in fact accurate. But that doesn’t make them any less silly. You can find a lot of truth in using hindsight to explain past performance but still find that hindsight useless in predicting what happens next, especially now.

Trading is all about human frailty. We live in a world with people who become greedy and shortsighted, who panic, who make blunders and then try to hide them, who try to protect their jobs, who lack experience, or who grow complacent. And all of this frailty and folly is in high relief in a modern world where nothing makes sense any longer. Seasoned traders talk of a time when they could sense where the market was going, when they could manage positions without desperation, when certain rules applied to how the markets would behave next month or next year. For many years, people with PhDs working at trading firms on Wall Street produced models that efficiently predicted market value for securities. However, these scholars failed to plan—or were unable to plan—for rare events, much less the current era of violent volatility and fiscal and social chaos. Further, the very value of experience itself has been called into question of late. A trader with 25 years of experience and a career noted for its rigorous success can now be found to be losing money six months in a row, while a new graduate—with a freshly minted MBA—can have a run on the market that can make him the toast, and the envy, of his older peers. Why? Skill or luck? Something else? We can no longer estimate how well a given trader will do based on that trader’s background.

As of this writing, it appears that the 25-year period of the “great moderation” is over, and, in fact, may have been somewhat of an historical anomaly. Since 2008, we’ve found ourselves struggling to deal with markets and an economy besieged by uncertainty.

Trading Options in Turbulent Markets is a book about how to think about options trading in terms of our modern world of randomness and volatility. This book was written with the hope of filling the void in traditional financial literature by combining theory and real-world practice with the awareness that the world we live in is completely random and that volatility is nothing but an expression of that randomness. The book draws from the premise that volatility isn’t just standard deviation or a number generated from the Black-Scholes calculator. It is the sum of all the information we simply don’t possess.

In an era full of so much uncertainty in all of the financial markets, and with the global investment community arguing about how well supercomputers can predict rare events—predict the unpredictable—I decided to write an expanded second edition about options trading. One can find an abundance of high-quality books about options trading, and plenty that address volatility analysis. I sought to write this second edition uniquely combining options trading and volatility in a universe that is beyond control and sometimes terrifying.

Face it; the past three decades have been the exception, not the norm, for investors in equity markets. To this day, Wall Street seems to be dedicated to the principle that when it comes to trading the markets, there is such a thing as expertise; that skill and insight count in trading, just as skill and insight count in surgery or baseball. But the common thread of this book is to show that options do not behave in the way that physical phenomena such as mortality statistics do. Physical events, whether death rates or card games, are the predictable function of a limited and stable set of factors and tend to follow what statisticians call a “normal distribution,” or a bell curve. Markets do not follow any normal distribution. Markets are not normal. This book is intended to help you understand that even though you may hear that 90 percent of all options expire as worthless, the 10 percent that don’t can create devastating results. The best computer modeling tools often fail to predict option contract prices and which options contracts are likely to be exercised. This uncertainty is largely caused by investors and traders who don’t act with any statistical orderliness. We change our minds on a whim. We do stupid things. We copy each other. We panic.

The options market has grown at a record pace over the past 25 years. Today, you can bet on whether a stock goes up or down. You can buy or sell options on bonds, on foreign currency, on mortgages, or on the relationship among any number of financial instruments of your choice; you can bet on whether the market booms or crashes or stays the same. Options allow investors to gamble heavily and turn 1 dollar into 50. They also allow investors to manage their risk. What drives the options market is the notion that the risks represented by all of these bets can be quantified, that by looking at the past behavior of a stock, you can calculate out the precise likelihood that the stock will reach a share price of $25.45 by next November 30, and whether the option is a good or bad investment at that price. Actually, the process is a lot like the way insurance companies analyze actuarial statistics in order to determine how much to charge for life insurance premiums.

But despite all the growth and the vast sums invested in derivatives trading today, we still face a stunning amount of uncertainty in the markets as in life. Addressing this uncertainty as options traders is what this book is about.

Part One focuses on how volatility in options trading relates to today’s stormy marketplace. The book reflects on the 2008–2012 era—a period full of randomness, uncertainty, and risk—and how this uncertainty leads to volatility in the financial markets. Of course the world has always been random, uncertain, and risky. But the financial markets were not so complicated even 25 years ago, the trade volumes and dollars invested were not nearly so vast, the markets were not dependent on enormously complex computer modeling tools, and the financial marketplace did not experience unprecedented volatility as it has over the last few years.

Part One also addresses how to manage risk and how to take advantage of market volatility when investing in derivatives. The book demonstrates how to take advantage of market volatility when investing in derivatives. It shows how to use historical volatility to predict the future volatility for a security, or the implied volatility. Part One deals with that odd feature of options trading known as skew, in which the options market has, in recent decades, essentially developed its own consciousness and can respond to market conditions that defy all logic. Skew is uncertainty squared. I describe how to work with skew or work around it.

Lastly, Part One confronts the overwhelming fixation with VIX—the self-proclaimed fear gauge of the market! This section helps to unpack VIX, providing the investor with practical application on what VIX is—what it isn’t—and how it can lead or even mislead in making options trading decisions.

Part Two digs into the tools for evaluating options trading decisions, the Greeks: delta, vega, theta, and gamma. It defines the values carefully and describes how each relates to volatility. Part Two takes this discussion one step further with an in-depth look into some of the more intricate details of volatility in an informative, easy-to-understand format. Institutional terms such as “realized volatility,” “term-structure,” “vol of vol,” and “correlations” are dissected with the investor in mind—boiling them down to where they can be both helpful and relevant to readers of all stripes.

Part Three provides strategies for trading options contracts in uncertain times. First, we address the decision-making process in broad terms and discuss how to become a steel-nerved trader. When does a trader know how to tolerate risk? How does a successful trader think or respond to adversity? How does a trader lose well?

Moving on, the book looks at specific options trading strategies to offset risk and reach for profit. These include the covered call, the naked and married puts, collars, straddles, vertical spreads, calendar spreads, butterflies, and condors, along with other various and sundry wingspreads. Part Three focuses on ways to use these strategies in a volatile market, how volatility affects each method of investing, and how to blend these strategies to control for risk. It explores how to open doors to making a profit even when nobody has any idea what is likely to happen next, when it seems there are long odds on any event other than the sun perhaps rising the next morning.

You can prosper in options trading, even in the midst of chaos. And despite the risks, options trading can be fun, invigorating, and, for a wise trader, an excellent means to profit, even in uncertain times.

PART I

Understanding the Relationship between Market Turbulence and Option Volatility

Chapter 1

Managing Risk and Uncertainty with Options

Trading in the financial markets can be summarized by the phrase, “You just don’t know what you don’t know.” On one hand, an investor can spend hours with research, due diligence, charts, and mathematical models only to end up with a worthless stock certificate, the result of a rare event that could not have been predicted. On the other hand, an investor can reap a bountiful reward on any stock, option, or future with less due diligence than that performed when purchasing a microwave oven. No charts or formulas involved—just plain profit resulting from old-fashioned intuition.

Today, the flow of information and the speed of its dissemination are simply astounding. In this age of electronic financial instruments, one can review information from a myriad of up-to-the-minute sources and subsequently amass a large trading position via a few clicks on the computer. Equally astounding is the sheer depth and liquidity of the exchange markets, where options are often quoted pennies wide and in multiple thousands on both the bid and offer. The markets have evolved from a disjointed fragmentation of phone calls and hand signals to a symphony of speed and synchronization.

Yet despite all the growth and development of the financial markets, there remains a great equalizer. Within the trading space there lies an element that is applicable equally to the eighteenth-century bourse trader, who anxiously awaited the latest information flow via flag signals along the stagecoach line between New York and Philadelphia, and to the twenty-first-century day trader, enveloping himself with television screens, statistical forecasts, and computer monitors.

The great equalizer—the factor that surpasses both time and knowledge—is volatility. Volatility is the ultimate unknown. No matter what is said, modeled, or written about it, volatility simply cannot be forecasted. Volatility amounts to risk to the investor. Learning to harness that risk is the subject of this book. Volatility and risk can be construed synonymously, and both terms are derived from uncertainty. In terms of the financial markets, uncertainty generates volatility, and volatility results in risk.

What Is Risk?

Risk is the direct result of a random event which has a quantifiable probability. The probability of an event—whether it is tomorrow’s weather, the outcome of a baseball game, or the closing price of a stock—can be determined by using either the practical observance of the frequency of past events or theoretical forecasting models. For instance, an observer with high school math skills can work out the probabilities of the possible outcomes of a card game. Similarly, economists use complex theoretical models to construe probability distributions for stock market returns.

It is also possible to calculate probabilities from past patterns of behavior when theoretical models are not available or reliable. For example, an insurance actuarial can estimate the probability that a motorcyclist will suffer a head injury by observing how frequently such injuries have occurred in the past. Similarly, casinos review probability distributions for blackjack winners on the basis of past winners.

What Is Uncertainty?

Uncertainty is . . . The concept of uncertainty is more intricate than that of risk. Whereas risk can be observed and quantified, uncertainty cannot. Uncertainty applies to situations in which the world is not well charted. The way in which the world operates is always changing—at least to the extent that observations of past events offer little guidance for the future.

Years ago, National Football League (NFL) owners were reluctant to televise games, believing that doing so would decrease ticket sales. Yet in actuality, the opposite occurred. Ticket sales in the NFL have increased significantly over the years, due in part to increased exposure through televised games. Ironically, concerns about the relationship between television and ticket sales changed when NFL owners began managing the observed ticket sales risk on the basis of previously observed relations between cause and effect.

All decisions typically involve some degree of both risk and uncertainty. Many choices are made in circumstances encountered for the first time, and uncertainty thrives in the relationship between cause and effect. Given that risk is quantifiable and more accessible to theoretical treatment than uncertainty is, it should be no surprise that literature on market randomness deals specifically with risk. Dismissing uncertainty—the conduit to volatility—can prove perilous to the investor.

Seven Lessons Learned from Market Volatility

An unprecedented number of financial crises have occurred in the past few decades. Without the benefit of hindsight, who could have predicted any of the turbulent market conditions over the preceding thirty-plus years? The list is formidable, including the breakdown of the Bretton Woods Agreement, the first oil crisis of 1973, Black Monday, the Japanese stock market crash, the collapse of Long-Term Capital Management (LTCM), the Russian ruble crisis, the Asian currency crisis, 9/11, Hurricane Katrina, the 2008 credit crisis, and the recent volatility of commodity prices. These rare events have had both short-term and long-term effects on market volatility.

Researchers who are conveniently removed in both time and emotion from such events have carefully documented and learned from them, whereas the average investor is still reeling from the too-recent, hard-hitting, real-life lessons of volatility and risk.

Macroeconomic data and fine points aside, several simple lessons about volatility seem relevant.

Lesson One

Financial crisis and market volatility often appear in waves. Like a tsunami, volatility is felt first on the shores of one country, followed by fierce waves appearing on other shores, often in very close succession. These financial tsunamis are often unleashed by episodes of economic weakness, political instability, and financial turmoil.

Lesson Two

The next wave of crises is sure to be different from the last. Money is made and money is lost in crises. Those who lose money typically set up safety measures to avoid incurring loss in the same fashion twice. As institutions evolve, those who profit during crises and other periods of volatility look elsewhere for weak points. From this simple dynamic, it follows that the next series of financial crises will be distinctive and different from previous debacles.

Lesson Three

Market volatility tends to be persistent. That is, periods of both high and low volatility typically persist for extended periods of time. In particular, periods of high volatility tend to occur when stock prices are falling and continue throughout rare events. The persistence of volatility is derived from the overall health of the economy, including volatility in economic variables such as inflation, industrial production, and debt levels in the corporate sector.

Lesson Four

Volatility is the product of an inefficient financial marketplace. It is rational to expect that financial markets will be efficient, setting prices at their real values, since buyers and sellers both behave according to rational self-interest based on broadly shared information about the economy and its individual parts. Yet people are often caught off guard when unexpected shocks—for example, severe drought, a sudden bankruptcy, or an aggressive change in government policy—disrupt the norm. Markets can and will move for any reason or for no reason at all.

Lesson Five

Volatility directly affects the average investor’s willingness to hold what is perceived to be a risky asset. In uncertain markets—volatile markets—humans tend to engage in a type of behavior that economists refer to as the “herding effect” and which floor traders effectively name a “bull rush.” This tendency creates a self-fulfilling prophecy: As more investors sell, it becomes increasingly likely that others will be convinced that there must be a good reason for them to sell also. The subsequent panic can actually serve to magnify trends instead of countering them. As a result, the implied volatility of stocks or options can move drastically without any real news to justify such a move.

Lesson Six

Sharp changes in the level of market volatility can discourage market participants from providing deep, two-way price quotations. The absence of a deep, two-way quotation, or liquidity, could potentially trigger adverse price reactions, which in turn can force irrational decision making, resulting in the wholesale liquidation of a position. It is absolutely essential that investment goals and theoretical knowledge about options are combined with an assessment of the possible hazards of ill liquidity.

Lesson Seven

Both the intensity and the frequency of investors’ changing beliefs about market fundamentals will directly affect market volatility. When investors’ sense of what the future holds is in flux, stock prices and option volatility will change rapidly, frequently, and significantly. This lesson is not necessarily intuitive, since one might expect uncertainty to generate only tentative volatility oscillations rather than huge waves of selling. However, such irrational behavior is what causes a trader to be convinced on Monday that the world is ending, and by Friday to be equally convinced that the world has weathered the storm.

Lessons Summary

Volatility is an alternate for investment risk. The persistence of volatility suggests that the risk and return tradeoff adjusts in a predictable fashion. That being said, options perform well as both potential portfolio enhancers and volatility reducers. However, options are not good or suitable if they cause an investor to make irrational judgments, chase returns, double up on losers, or engage in risks that are better absorbed by those who are more capable and more appropriately positioned to take them.

Understanding Derivatives

Derivatives are financial instruments whose value and guaranteed payoffs are derived from the value of something else, generally called the underlying. This underlying is often a singular company or a government’s interest rate, but it definitely does not have to be. For instance, derivatives exist based on the price of the Standard & Poor’s 500, the temperature at O’Hare Airport, the number of bankruptcies filed among a group of selected companies, or even the implied volatility of the market.

There are two variations of derivative products: plain vanilla and exotic. Plain vanilla derivatives are defined as either an option or future contract. Exotics conjure up names like “knock-outs,” “double-touch,” or even “barrier options,” and they are far beyond both the intention and scope of this book.

Options Defined

An option is a contract to buy or sell a specified quantity of an asset at a fixed price at or before a predetermined date in the future. An option can be bought or sold at the asset’s current price (at the money), well below the current price (in the money), or far above the prevailing traded price (out of the money). In addition, options contracts can be traded with expiration dates ranging from one day to several years in the future. Exchange-traded options can be bought or sold at any time, although there is a specific difference in expiration style. An American style option can be exercised at any time on or before its expiration date. A European style option can be exercised only on its expiration date.

Futures Defined

A futures contract refers to a standardized contract to buy or sell a particular commodity of consistent quality at a predefined date in the future at a market-determined price.

For example, a corn future is a contract to buy or sell a specified amount of physical corn at the market-determined price. Similarly, a futures contract on XYZ stock gives the buyer of the futures contract the right to buy a predefined quantity of XYZ at the present market price. The vast majority of futures contracts end up being closed out as a result of buying or selling in the marketplace. Physical delivery does occur, but only on the future’s settlement date, which transpires at a predefined time once per quarter.

Understanding Options

Although options can be traded on just about anything imaginable, let’s use options on common stock as an example. A call option gives its buyer or holder the right—not the obligation—to buy a fixed number of shares at a given price at some future date. A put option gives its buyer the right to sell a fixed number of shares at a given price at some future date. The specified price is called the exercise price. The seller of an option at its beginning is called the writer. When the buyer (holder) of an option takes advantage of his right, he is said to have exercised his option. A holder (purchaser) who cannot gain from exercising his option before expiration either sells his option to close or allows the option to expire. The purchase price of an option is called the option premium. Options enable buyers to leverage their resources while limiting their risk.

The Six Benefits of Options

Although exchange-traded options have existed since 1973, many investors have chosen to avoid them, deeming them to be either too risky or difficult to understand. Others have had bad experiences with options because neither they nor their brokers were properly trained in how to handle them strategically. Although options can be difficult, risky, and downright frustrating if not strategically employed, they don’t necessarily need to be. A game plan that includes a reasonable risk/reward profile and an ironclad exit strategy can help the investor reduce the ill effects of volatility and improve the possibility of enhanced returns.

Benefit One: The Ability to Leverage

Options provide both individuals and firms with the ability to leverage. In other words, options are a way to achieve payoffs that would usually be possible only at a much greater cost. Options can cause markets to become more competitive, creating an environment in which investors have the ability to hedge an assortment of risks that otherwise would be too large to sustain.

Benefit Two: Creating Market Efficiency

Options can bring about more efficiency in the underlying market itself. Option markets, in and of themselves, tend to produce information flow. Options enable investors to access and trade on information that otherwise might be unobtainable or very expensive. In the equity market, for instance, short sales of stock are often difficult to apply. This difficulty slows down the speed with which adverse information is incorporated into stock prices and makes markets less efficient. With put options, investors can more easily take advantage of adverse information about stock prices.

Benefit Three: Cost Efficiency

Derivatives are cost efficient. Options can provide immense leveraging ability. An investor can create an option position that will imitate a stock position identically, or almost identically, although at a large cost savings. For example, in order to buy 500 shares of a $20 stock, an investor must outlay $10,000 (500 shares × $20 = $10,000). However, if the investor were to purchase five $20 call options (with each contract representing 100 shares), the total outlay could be far less. For example, if the investor bought five 30-day $20 calls for, say, $2 each, he would spend $1,000 ($2 × 100 shares × = contracts = $1,000) to somewhat replicate the stock for a 30-day period. In practice, stock replication is not always as straightforward as this example implies. The investor must choose the right call to purchase, determine the optimum time frame, have a solid understanding of the implications of volatility, and be familiar with the greeks.

Benefit Four: 24/7 Protection

Options provide relative immunity to potential catastrophic effects of gap openings in the underlying. There are numerous circumstances in which buying options is riskier than owning the underlying, but there are also times when options can be used to reduce risk. It really depends on how you utilize them. Employed efficiently, options can serve as the most dependable form of hedging.

For instance, when an investor purchases stock, a stop-loss order is often placed to protect the position and to prevent losses below a predetermined price set by the investor. The stop order is executed when the stock trades at or below the limit indicated on the order. The risk with stop orders is inherent in the nature of the order itself.

For example, suppose you purchase XYZ stock at $30. You do not wish to lose any more than 15 percent of your investment, so you place a $25.50 stop order. This order will become a market order to sell if the stock trades at or below $25.50. This type of order is effective during the day, but it could prove disastrous after the market closes. Suppose that the next morning there is terrible news about XYZ, and the stock is expected to open at around $5. When the market opens, your stop-loss will be triggered at $5, since it is the first price below your initial stop-loss implementation—which means you end up taking a considerable loss on the trade. The stop-loss strategy simply did not work when you needed it most.

Had you purchased a put option for downside protection, you would not be subject to such a catastrophic loss. Unlike stop-loss orders, options do not shut down when the market closes. They offer insurance twenty-four hours a day, seven days a week—something that stop orders can’t do.

Benefit Five: Flexibility

Options are flexible tools that offer a variety of investment alternatives. Options can present the investor with a means to capture downside opportunity or to hedge downside risk. Many brokers charge a cost-prohibitive margin when the investor wants to short a stock. Other brokers simply do not allow for the shorting of stocks. This inability to trade or to effectively hedge the downside virtually handcuffs the investing public, forcing them onto an uneven playing field with the professional trading community. Options offer the individual investor a way to hedge a myriad of risks under specific circumstances.

Benefit Six: Trading Additional Dimensions

Implementation of options opens up opportunities of additional asset classes to the investor that are embedded in the options themselves. Options allow the investor not only to trade underlying movements, but to allow for the passage of time and the harnessing of volatility. The investor can take advantage of a stagnant market or a range-bound market. Unlike the traditional “buy and hope” investment theory, options, if applied correctly, can serve to limit downside exposure, stop a loss, and lock in a range for possible profit. Options can provide flexibility and a genuine risk/reward profile like no other investment. In many ways, options are profoundly confusing. But at the same time, they can be easy to understand.

Chapter 2

Making Sense of Volatility in Options Trading

Volatility is a measure of instability. A volatile substance will tend to change its form easily—for example, a liquid with a low boiling point readily turns into a gas. Gasoline is volatile; this doesn’t mean that gasoline can catch fire easily (although it can), but rather that gasoline gives off fumes even at low temperatures. The volatility of gasoline increases its flammability because in its vapor form, it is much more likely to be ignited by, say, static electricity than it is as a liquid.

In the financial markets, volatility refers to the likelihood that securities or indexes will change in value over time, which can be determined on the basis of either past events or implications for the future. Usually the term is applied to stocks and to options contracts based on those stocks. The share price for a volatile stock will tend to fluctuate considerably over time. But this simplistic approach to volatility lacks nuance. An uninformed investor may think volatility is all about risk and liability—in other words, volatility in the market results in losing money. But if volatility is managed properly, it can be used to derive benefit. Either way, most traders tend to think of volatility as both an opportunity and a plague. It can be difficult to live with, but option contracts cannot be traded without it.

Volatility is a fundamental market force, and it must include risk. But traders can also take advantage of market volatility and prosper from it. Those who see profit in volatility understand that the volatility measurement for any security is based on market forces and anticipates the likely future value of the underlying security. They also understand that volatility describes how the value of a security moves up as well as down over time. Volatility is not merely an indicator that shows how share prices are likely to drop.

Volatility as an Asset Class

An asset class is a group of related securities, such as stocks or futures contracts. All assets are defined by how fair market value is calculated. Real assets, including stocks, bonds, real estate, commodities, and even collectibles such as rare baseball cards, have an intrinsic and identifiable value. Currencies are considered nominal assets, because dollars or euro or yen have no value apart from the good faith of the issuing government and the economic strength of the host country. A wasting asset has a limited shelf life and loses value over time. If tomatoes (perhaps homegrown ones) were considered assets, they would be wasting assets. So are options contracts. Options contracts are valuable only as long as they can be exercised. When an options contract expires, it becomes worthless. Most options contracts tend to lose value as they approach the expiration date, because a change in share price that would make an out-of-the-money contract worth exercising becomes less likely as time runs out.

Some traders consider volatility itself as an asset class, and they trade in volatility for underlying stocks or for the options contracts based on those stocks. Any asset can be traded if it has a risk dynamic that can be marketed. A risk dynamic is a market exposure that can be protected through hedging but which is hard to flatten out or diversify. Risk factor can be traded by calculating its value and assigning a price to it. This applies to volatility as well. Volatility is an expected result of any asset that features risk, and this volatility can be estimated for an asset in the future. Volatility values are quoted in real time and trade on options markets throughout the world.

Any asset’s future volatility is unknown, so traders developed models in the 1970s, not long after the Chicago Board of Options Exchange (CBOE) opened, to project volatility over the lifetime of options contracts. Consequently, the concept of implied volatility was born. Market makers are specially designated traders under contract to provide price quotes for buying and selling specific securities on exchanges in order to set a price range to facilitate trading. Options market makers sometimes believe that options contracts are mispriced and thus trade based on the implied volatility in order to profit from this mispricing.

Volatility buyers believe that the implied volatility for an options contract will cost less than the underlying volatility likely to occur over the lifetime of the contract. Volatility sellers