"The Volitility Edge in Options Trading" Jeff Augen Flashcards
Date that Options began trading on the CBOE
April 1973
European style options can be exercised when?
only at the time of their expiration
Anerican-style options can be exercised when?
anytime during their life
early exercise of ITM options does not happen, why?
because it involves discarding the remaining time premium
The random-walk hypothesis asserts that…
asserts that the evolution of market prices cannot be predicted
The random-walk hypothesis is antagonistic to what school of thought…
technical analysis, chart patterns with predictive power
EMH
Efficient market hypothesis: predicts that market inefficiencies due to chart patterns do not exist.
EMH’s 3 basic forms of efficiency
Weak Form; Semi Strong; Strong form
Weak-form efficiency implies
that technical analysis cannot consistently produce positive returns; but recognizes the possibility of producing some return based on fundamental analysis of business performance and economic climate
Semi Strong efficiency implies that…
fundamental analysis is insufficient to yield positive returns. It assumes that share prices adjust to publicly available information almost instantaneously, making it impossible to place profitable trades using the new information.
Strong-form efficiency implies that…
share prices alone reflect all available information at any given moment
strong-form efficiency implies that an individual cannot outperform the market. T or F?
F: individual traders can outperform or under perform the market as long as the entire group’s performance remains normally distributed
can strong form efficiency exist where insider trading is illegal?
No, because all information must be priced into the market
normally distributed 1, 2, and 3 SD percentages
1: 68.2%; 2: 95.4%; 3: 99.8%
OTM options are nearly never exercised early because
it would mean buying or selling a stock at a loss immediately
Implied Volatility (IV) is found by
solving for the Volitility variable using the pricing model and using the option’s current price
Historical Volatility (HV) is found by
through observed volatility of the price movement of the underlying
dividends normally have what affect on what options
dividends normally act to reduce call prices
Put-Call Parity: C =
P + S = C
Put-Call Parity: P =
C - S = P
Put-Call parity: S =
C - P = S
Define Delta
The value effect of a $1 increase in the underlying: Delta
Define Gamma
The delta’s rate of change: Gamma
Define Vega
The effect of a 1% increase in volatility
Define Theta
The rate of time decay (usually expressed in dollars/day)
Define Rho
The effect of a 1% increase in the interest rate
The price difference between two calls or puts with same month and adjacent strike is what greek
Delta is the difference between two puts or calls with same month and adjacent strikes
The price difference between two calls or puts with same month and adjacent strike is what greek
Delta is the difference between two puts or calls with same month and adjacent strikes
is a position with positive delta bullish or bearish position?
bullish
Is Delta affected by time?
Yes, the Delta of OTM options move closer to 0, and ITM options move closer to 1 as expiration approaches
short calls and short puts always have ___________ gamma
negative gamma
long calls and longs puts always have _________ gamma
positive gamma
is a position with negative delta bullish or bearish position?
bearish
long or short the underlying has _________ gamma
zero gamma, long underlying always has a delta of +1 and short underlying always has a delta of -1
Negative gamma has what affect on delta
negative gamma will adversely affect the delta in the direction that benefits the trade as the trade continues to move in that direction; Negative Gamma = bad hedge for the position
positive gamma has what affect on delta
positive gamma will enhance/grow the delta in the direction that benefits the trade as the trade continues to move in that direction; +Gamma = good hedge for the position
Will gamma be higher or lower for an OTM long put after time has passed?
closer to zero
Does time passing have an impact on Gamma?
Yes, Gamma changes with time and depending on OTM, ITM, or ATM the affects of time passing are different
Will gamma be higher or lower for an OTM long put after time has passed?
closer to zero
The most successful hedges have what type of gamma
those that are long large amounts of gamma
What does a Vega of .25 indicate?
that the option price will increase $.25 when the volatility priced into the option rises 1%
When the IV of the option decreases 1%, what will happen to the price of the option
The price of the option will decrease by the amount of the Option’s Vega
Far OTM and ITM options are sensitive to changes in volatility? T or F
F: neither is very sensitive to changes in volatility
How does Volatility affect ATM options as expiration approaches?
Volatility has a lesser affect on ATM options as expiration approaches;
ATM options become more sensitive to changes in volatility as expiration approaches? T or F
F: ATM options become much less sensitive to changes in volatility as expiration approaches
How does Volatility affect ATM options as expiration approaches?
Volatility has a lesser affect on ATM options as expiration approaches;
It is possible for an options trader to generate a positive return without a reliable method for assessing volatility?
NO: An option trader MUST have a reliable method for assessing volatility in order to generate a positive return
which single variable in the options pricing model does NOT have a precise known value?
Volatility
Volatility derived from the past behavior of the underlying is _________
Historical Volatility
volatility derived from the current price of the option is ________
Implied Volatility
Volatility derived from the past behavior of the underlying is _________
Historical Volatility
find the one week, 1SD price move for a $50 with 25% annual volatility
.25 * (sqrt of (1/52)) = .03466 * $50 = 1.73
formula for a 1SD move for any given time period…
(annual volatility) * (sqrt of time period) * (price of underlying);
Fair Volatility is…
the Trader’s assessment of Volatility independent of but after consideration of Implied Volatility and Historical Volatility
How important is Fair Volatility to an Options trader?
It is nearly impossible to generate a positive return without a reliable method for assessing Fair Volatility
Does an options pricing model exist that can accurately price options based on anticipated big market events seen or unforeseen?
No, Even the most refined option pricing models cannot anticipate earning surprises, hostile takeovers, stock buybacks, fraud, wars, trade embargoes, terrorist attacks, political events, etc
Buying and selling options is tantamount to buying and selling…
Standard Deviations
many traders fall into the trap of comparing price changes in ___________ rather than ___________.
Percentages rather than Standard Deviations
Put and Call deltas are symmetrical. T of F?
False: Put and Call deltas are not symmetrical, related to the lognormal distribution
Binomial Trees are…
An alternative option pricing model that extrapolate out all price movement possibilities to the 2^30 (1 billion) iteration to determine option pricing
Advantage of Binomial Tree Pricing model to the Black-Scholes
the binomial model can be used to simulate the differences in Volatility change along with time and underlying price movement
Cox-Ross-Rubenstein model, AKA…
Binomial Tree option pricing model
number of trading days in a year
252
Jeff will call a underlying “well behaved” if…
Well Behaved if the size and distribution of its price changes fit the normal distribution curve
Jeff will call an underly “poorly behaved” if…
Poorly behaved: if its price change distribution curve has elongated tails with a surprising number of large spikes
Jeff Augen will say that the principal goal of an option trader is to…
is to arbitrage subtle difference between implied and fair volatility by structuring positions that capitalize on those discrepancies
In order to generate a profit, the underlying must rise or fall, more or less than the amount of volatility priced into the position/trade. T or F?
True, without taking advantage of mis-priced implied volatility, a consistent profit is unattainable according to Jeff Augen
Jeff will advise that once the position volatility is fairly priced…
The trade becomes a direction bet
volatility is mean-reverting. T or F?
True. If current Volatility is low, it tends to rise, and if it is high, it tends to fall.
Decisions about structuring positions should take into account both the relative difference between _________ and ________ volatility and the trade’s ________________.
both the relative difference between implied and fair volatility and the trade’s time horizon.
It is important to make sure that the time horizon of a structured position does not overlap with the…
next transition between the stock’s low and high volatility
