Primer on Options and Volatility Strategies - CBOE

Primer on Options and Volatility
Strategies

3rd Annual RMC Europe - Ireland
Colin Bennett, Santander; Paul Stephens, CBOE
September 2014



Primer on Options and Vo

Outline
Volatility Risk Premia
Hedging / Long Volatility Strategies
VIX® and Volatility Trading

CBOE

olatility Strategies

Copyright © 2014 Chicago Board Options Exchange, Incorporated. All rights reserved. 2

Volatility Risk Prem

mia

CBOE Index Option Strate

S&P 500®

BXMSM

– Long S&P 500, with dividends, sho

BXYSM

– Long S&P 500, with dividends, sho

PUTSM

– Long treasuries, short first availabl

CLLSM

– Long S&P 500, with dividends, sho
SPX put

Russell 2000®

BXRSM

– Long Russell 2000, with dividends

CBOE

egy Benchmarks

ort first available OTM 1-month SPX call
ort 2% OTM 1-month SPX call
le OTM 1-month SPX put (fully collateralized)
ort 10% OTM 1-month SPX call, long 3-month

s, short first available OTM 1-month call

Copyright © 2014 Chicago Board Options Exchange, Incorporated. All rights reserved. 4

Benchmark Returns and Volat

Sources: Bloomberg, CBOE and Citigroup Fixed Income Indexes.

CBOE

tility Over 25 Years

Copyright © 2014 Chicago Board Options Exchange, Incorporated. All rights reserved. 5

www.cboe.com/benchm

Total return indexes reflect reinvested dividends, but indexes may
performance is not predictive of future results.

CBOE

marks

not reflect all transaction costs and are not investable. Past

6

Copyright © 2014 Chicago Board Options Exchange, Incorporated. All rights reserved. 6

The Source of Outperform

Why does it work? Volatility Risk Pr

Implied Volatility vs Historical Volat

Current IV has historically been greater
Insurance Risk Premium – Investors pa

* Chart - Pension Consulting Alliance Inc. (PCA) presentation at 2014 CBOE Risk Ma

CBOE

mance

remium

tility

r than subsequent HV
ay a premium for Insurance

anagement Conference || Options-based strategies in Public Pension Funds
Copyright © 2014 Chicago Board Options Exchange, Incorporated. All rights reserved. 7

Quiz Rules

Rules For Quiz

Need to get ALL questions right (
top scorer gets a mystery prize)
Have to do quiz on your own (no
No Santander employee (or relatio
No CBOE employee (or relations)
Must answer question before I giv

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(if no one gets all questions right,
merging scores with colleagues)
ons) can win
) can win
ve the answer

8

Question

What is the fair price of implied v

Below expected future realise
Equal expected future realised
Above expected future realise

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volatility?

ed volatility (WHITE)
d volatility (RED)
ed volatility (GREEN)

9

Implied should be above r

Assuming a positive equity risk pre
realised

Implied volatility is on average 1-2 pts ab
Short volatility strategies are effectively l
correlation)
If long equity is expected to earn more th
premium) then short volatility should also
Fair value of implied volatility is therefore

Structured products selling varianc

Shorting implied volatility is an opportuni
going long equity
There are many structured products bas
have suffered in the downturn as volatilit

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realised

emium, implied vol should be above

bove realised volatility
long equity risk (assuming negative spot vol
han the risk free rate (i.e. positive equity risk
o be profitable (as exposed to the same risk)
e above realised volatility

ce contain equity risk

ity, but returns are likely to be similar to
sed on selling variance swaps, their returns
ty spiked and equities fell

10

Call overwriting can yield
returns

Reasons why volatility is usually ov

Demand for protection
Unwillingness to sell low premium (n
High gamma of near dated options h
Index implied lifted by structured pro

Call overwriting can improve portfo

Selling expensive implieds can lift p
position is lower (reduces benefit of
On balance call overwriting has te
most market environments (excep

CBOE

enhanced

verpriced

near dated) options
has gap risk premium
oducts

olio performance

performance, but note that the delta of
equity risk premium)
ended to be a winning strategy in
pt in very bullish markets)

11

Question

Is volatility (standard deviation)
call overwriting?

No (RED)
Yes (GREEN)

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the best measure of risk for

12

Overwriting with 1 month
strike may be optimal

Strike of optimal strategy depends o

Overwriting with near dated options tend
options in a year, but only 4 three month
options can be seen as more risky (if ma

Equities must have a realistic positive re
optimum strike is < ATM). In these period
SX5E options (107-108% for 3 month op

Strike should be higher for higher volatili
calls)

Call overwriting

103% 104%
102%
105%
106%

101% 108%

100% 110%

Exact peak strike for overwriting
depends on period of backtest

-8% -7% -6% -5% -4% -3% -2%

Call overw riting volatility - index volatility

CBOE

104%

on period of time examined

ds to outperform as can sell 12 one month
h options. BUT selling multiple short dated
arkets rise one month, then fall)
eturn during back test period (negative return
ds a strike of 103-104% is best for 1 month
ptions).
ity stocks (rule of thumb is use c25% delta

3.0% Call overwriting return - index return Only upside risk is
reduced (use
2.5%
Sortino ratio rather
2.0% than standard dev)

1.5%
%

1.0%

0.5%
Index

0.0%
-1% 0%

13

Question

Do you get best outperformance
or single stock?

Index (RED)
Single stock (GREEN)

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e from call overwriting an index

14

Performance depends on
environment

Overwriting may be optimal on an in

Overwriting outperforms, but there were
Index implieds are more overpriced than
As call overwriting less attractive for sing
call overwriting can lift returns

Relative performance (rebased) S&PC5a0ll0ove1rwmritiAngTpMerforcmaanllceodvepeenrdws or
140

130

120 Start of late
90's bull market
Call overwriting
outperforms

110

100
Asian
crisis

90

Call ovewriting
underperforms

80

70 1989 1990 Outper f orm 1993 1994 Signif icantly Breakeven
1988 1991 1992 Underperf orm 1998 1999

1995 1996 1997

BXM / S

CBOE

ndex rather than single stock

e periods where it underperformed
n stocks (implied correlation too high)
gle stocks, there is greater chance enhanced

ornitminarkgetpenevirrofnomremnt ance since 1988 2009
trough
2003
trough

Credit
crunch

TMT
peak

n Significantly Underperf orm Signif icantly Signif icantly
Outperf or m Outperf orm Underper f orm

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
S&P500 total return

15

Hedging / Long Vola
Strategies

atility

Hedging

Hedging

Individual Underlying, Sector, or Ind

– Buy Puts
• Defines Risk
• Allows to maintain position an

Tail-Hedge

– Hedges overall Portfolio
• Buy SPX Puts
• Buy VIX calls

CBOE

dex

nd still reap upside

Copyright © 2014 Chicago Board Options Exchange, Incorporated. All rights reserved. 17

VXTHSM - CBOE VIX Tail H

VIX futures less than or equal to 15 N
VIX futures above 15 and less than or equal to 30 1
VIX futures above 30 and less than or equal to 50 ½
VIX futures above 50 N

CBOE

Hedge Index

No VIX calls are purchased
1% of portfolio in 30 delta VIX calls
½% of portfolio in 30 delta VIX calls
No VIX calls are purchased

Copyright © 2014 Chicago Board Options Exchange, Incorporated. All rights reserved. 18

Question

What may be the optimal protect

Deep Out Of the Money or DOO
Put spread (RED)
Selling your equity position (G

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tion strategy?

OM puts (WHITE)
GREEN)

19

Markets can crash, correc
enter bear market

DAX declines since 1959 can be gro

Crash has a high annualised decline (

Near dated DOOM puts best

Bear markets are multiple year declin

Best to exit position (long dated protection

Corrections are remaining declines o

Put spreads may be optimal (or put sprea

Average Average Av
Duration decline

Crash 1 month 31%

Correction 3 months 14%

Bear market 2.4 years 44%

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ct or

ouped into 3 categories

(c90%) for a period of 3 months or less

nes of 23% or more

n is too expensive)

of up to a year and up to 22%

ad collar or knock out puts))

verage annualised Duration Decline
range
decline range

96% < 3 months 19% - 39%

58% <= 1 year 10% - 22%

26% 1-5 years 23% - 73%

20

Delta hedging gives vol ex

Delta hedging removes equity risk

• Delta is the measure of equity risk (by definition a

long equity position has delta = 1 = 100%)

• Delta hedging is the process where the equity risk

an option position is removed by going long or sho
stock (e.g. a long call is delta hedged by going sh
stock).

• Profile of delta hedged call, put and straddle is

identical (are all convex).

Gamma scalping locks in profit

Assume an investor has a long volatility position
(e.g. long call, put or straddle) that is delta hedged
(i.e. delta = zero).

If underlying falls shares need to be bought
If underlying rises shares need to be sold
Gamma scalping (delta rehedging) always gives a
profit.
Profit from gamma scalping is offset by cost of tim
decay (theta), i.e. the fact time value of option
decreases approaching expiry.

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xposure

a Profit20 Delta hedging

k of 10 Delta hedged (call + short stock)
ort position profits from a movement
hort 0
20 up or down in equity market

30 40 50 60 70 80

-10

-20 Stock price

Call price † Short stock Call + short stock

d 60 Rehedging locks in profit
50
a 40 3) Now have +ve delta
me 30 hence close long and go short
20
Premium (€) 10 2) As have -ve delta buy
shares to return to zero
0 delta (and lock in gains)
0
1) Start (zero delta)

25 50 75 100
Straddle Straddle + long stock Straddle + short stock Stock price

21

Question

If an index (c20% vol) rises 10%
profitable strike for a 1 year call

ATM (WHITE)
ITM (RED)
OTM (GREEN)

CBOE

in 1 year, what is the most
option?

22

ITM options trade like a fu

ITM options have highest delta, hen
confident

Typically investors trade ATM or OTM op
Highest return for a given market move o
more than outweighs their higher cost (IT
ITM options do not have much convexity
strategy as the high cost of ITM options

Return Profit of 1 year call if markets rise 10%

ITM options have highest profit

40%

35%

30%

25% OTM options have low
profit due to low delta

20%

15%

10%

5%

0%

Strike

CBOE

uture

nce highest return if investor is

ptions as they are cheapest

occurs for ITM options, as their higher delta
TM options similar to futures)

y (compared to ATM), hence is a risky
could be lost

Breakdown of 1 year call profit if markets rise 10%

Strike Premium Payout Profit Profit (% of
premium)

90 15 20 5 33%

95 12 15 3 25%
100 9 10 1
105 6 5 -1 11%

-17%

23

Question

If a stock (c30% vol) falls 10% in
profitable structure?

Long put (RED)
Long call spread (GREEN)

CBOE

n 1 year, what is the most

24

ITM call spreads can be pr
when equities decline

Unless underlying moves are excep
than delta

If an ITM call spread is purchased, the s
(hence the structure earns theta)

For a 10% decline, an ITM 85-90% call s
whose strikes are 5% apart). Profit from
than a put (if equity decline is not excess

Buying an ITM call spread is a viable tra

PrRoetfuirnt of 1 year call spread and put if markets fall 10

70%

60%

50% Max call spread profit is above 60%
while max put profit is below 30%

40%

30%

20%

10%

0% 85% 90% 95% 100% 105% 110
80% Call spread (5% wide) profit Put profit
S

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rofitable

ptional, you earn more from theta

short call is more ATM than the long call

spread earns peak profits (for call spreads
buying an ITM call spread can be greater
sively large)
ade for fixed income investors

0% Breakdown of 1 year call spread profit

Strikes Premium Payout Profit Profit (% of
premium)

75-80 3.81 5 1.19 31%

80-85 3.49 5 1.51 43%

85-90 3.14 5 1.86 59%
2.79
0% 90-95 0 -2.79 -100%

Strike

25