Here is your teacher waiting for Steve

Wynn to come on down so I could

explain index options to him. He never
showed
h d so I guess th
thatt he
h will
ill have
h to
t
download this lecture and figure it out
like everyone else. He was a nice host,
though. And he seems very interested in
math. A lot of things going on in this
large curved building behind me seemed
to have a connection to math.

Advanced Options Trading Strategies

... (part 1) options basics 104 review
Read chapter 7 and review lectures 8 and 9 from Econ 104 if
© 2014 Gary R. Evans you don’t remember this stuff.
   Weights I want you to finish
INTC 0.250
yours so that it gets
So what are we to make
BAC 0.250
MO
JWN
0 250
0.250
0.250
this result ... we are
not done.
of this?
Sum:  1.000

DCGR Mean Var SD Can you understand why ...

INTC 0.00093 0.000166 0.01288
BAC 0.00104 0.000216 0.01469
MO 0.00086 0.000080 0.00897 1. This is a good portfolio as is ... we have a
JWN 0.00065 0.000118 0.01088 volatility that is lower than the volatility
Correlation Matrix
of our least volatile stock (0.0081
INTC BAC MO JWN comparedd to 0.00897)!
0 00897)!
INTC 0.23317 0.26090 0.24442
BAC 0.30034 0.35182
MO 0.38890 2. Why these numbers in the covariance
JWN
matrix must be reallyy low!
Covariance Matrix
INTC BAC MO JWN
INTC 0.0000441 0.0000301 0.0000342
3. What we would do if we found a number
BAC 0.0000396 0.0000562 in the correlation matrix above our
MO 0 0000380
0.0000380 th h ld (say
threshold ( 0.4
0 4 or 0.5).
0 5)
JWN

4. What we would do to raise our alpha!

Weighted portfolio variance:   6.65674E‐05  
Weighted portfolio volatility:  
e g ed po o o o a y 0.0081589
5. What we would to to get an optimal
Portfolio alpha:  0.000869016
Annualized Portfolio alpha:  0.218123077 risk/yield tradeoff for these four stocks.
The relevance of this to the Long-
Long-Term Capital story
Remember that professional exotic investments by Hedge Funds will select very
high alpha and very high beta investments like sovereign debt, distressed debt,
exchange-rate
h d
dependent
d equity i investments,
i emerging
i market
k equities,
i i etc. andd
they know that safety is in numbers ... if the investments are uncorrelated.

Theyy are often fundingg out of spreads

p from a carry-trade
y of come kind,, borrowingg
at 2% and looking for alphas of 6% or 7% or higher. The borrowing gives them
leverage inverse to the percentage of their equity stake (10% equity stake gives
them 10 to 1 leverage). Running to a higher-yield asset at times like 2013 and
2014 iinvolves
l bbuying,
i say, sovereign
i ddebt,
bt th
thatt hhas a hi
high
h probability
b bilit off default.
d f lt

You should understand by now that given any portfolio variance, leverage
p p y L2((V).
modifies the volatilityy proportionately ) This means that a 5% loss becomes
a 50% loss in this scenario (ask students about the math of this).

Of those covariances go from near zero to one in a market panic, you are dead.

[Read page 188 and 149]

Standard & Poor’s Estimated Average Cumulative
Default Rates for various credit ratings
... showing their
estimates of the
estimated
i d cumulative
l i
default rate (e.g. the
estimate of a CCC/C
jjunk bond defaultingg
within 2 years is above
30%, within 7 years is
above 45%).

Source: Standard and

Poor’ss Global Fixed
Poor
Income Research, “The Remembering actual default rate
Time Dimension of probabilities of junk
junk--rated debt from
Standard & Poor’s Credit Econ 104:
Ratings,” September 22,
Ratings,
2101, p.3 Chart 1.
 Statistical Arbitrage
g
(stat arb)
Statistical Arbitrage (called stat arb) is a "quant"
quant strategy used by many of the
largest hedge funds, like Citadel. Generally stat arb involves building an equity
portfolio of mixed long and short positions in stocks.
Typically
i ll the
h hedge
h d fund
f d strives
i to make
k the
h portfolio
f li "marketk neutral,"
l
meaning that performance does not depend upon a rising or falling market.
Because the return marginsg on these enormous portfolios
p are usuallyy pretty
p y
thin, stat arb portfolios are usually hugely leveraged (maybe 100 to 1) by
cheap borrowed money (e.g. carry trade or commercial paper).
Stat Arb also uses delta hedging (theoretically) so we will come back to
discuss this in the future.
Obviously an old example
Stat Arb ((cont.))
Dow Jones Industrial Averages 30 components

AA Alcoa HD Home Depot MO Altria

AIG AIG HON Honeywell MRK Merck
AXP American Express HPQ Hewlett Packard MSFT Microsoft
BA Boeing IBM IBM PFE Pfizer
C Citicorp INTC Intel PG Procter Gamble
CAT Caterpillar JNJ Johnson & Johnson T AT&T
DD Du Pont JPM JP Morgan Chase UTX United Technolgies
DIS Disney KO Coca Cola VZ Verizon
GE General Electric MCD McDonalds W MT W al Mart
GM General Motors MMM 3M XOM Exxon Mobile

Suppose we take a market basket of stocks, like the index above (but not
restricted to indexes ... this is an example), and suppose we are bullish on the
index, but not every stock in the index. We therefore decide to go long in most
stocks but short some of them (shown in red in the example above, based upon
l t 2007 markets).
late k t) BButt iin what
h t quantities?
titi ? This
Thi is
i where
h statt t arb
b begins,
b i with ith a
portfolio of longs and shorts, like any hedge fund. But stat arb also aspires to be
market neutral.
 Stat Arb Market Neutrality
Statistical Arbitrage builds an equity portfolio of longs and shorts (see
previous slide) but stat arb also typically aspires to be "market neutral." This
means that
h ideally
id ll the h portfolio's
f li ' performance
f is
i not improved
i d by
b either
i h a rise
i
or decline in the overall index (or portfolio). In the previous example, this
portfolio, if correctly weighted to be "market neutral," would be insensitive
to a rise or fall in the DJIA
DJIA. [Your teacher once asked a stab arb desk
supervisor, a Mudder, whether he thought the market was going to rise or fall
in emerging months. His answer was, "Who cares?"].
How do they achieve market neutrality? On the risk side, they use some very
complicated algorithms to assess portfolio risk to make the portfolio risk
neutral. We will learn that approach in a few weeks when we cover advanced
volatility.
l tilit
What therefore is the basis of profitability? Generally, you have to be more or
less right about the longs and the shorts. In a rising market, the longs have to
rise more than the shorts. In a falling market, the shorts have to fall more than
the longs.
 Stat Arb Problems??
Stat arb has been seen in recent years as the coolest of the quant strategies, but in
the fall of 2007, in the midst of the sub-prime meltdown, that some stat arb
h d ffunds
hedge d hhad
d bbeen llosing
i money, something
hi they
h were not supposedd to do. d
At issue (teacher's comments):
1. Theyy are heavily
y leveraged.
g
2. Their borrowing source is (was) a troubled market.
3. Some bullish bias may have been built into some of these funds.
4. "Quantagion?"
Financial Contagion
g or "Quantagion"
Q g
(a dangerous new phenomenon?)
[Not required, but recommended, for class]: see "What Happened to the
Quants in August 2007?" by Amir E. Khandani and Andrew W. Lo,
September 20, 2007 draft available on
http://www2.hmc.edu/~evans/khandanilo.pdf
l
later versions
i possibly
ibl available
il bl on
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1015987.

What happens when large hedge funds use huge amounts of

leverage and start using identical or nearly identical trading
strategies?
First, profit ranges must narrow, which may require even more
leverage.
Margin calls, credit drying up, etc., may force severe correlated
liquidation.
 Our recent HPQ strangle
Name: Gary R. Evans
Date: February 26, 2014

I compare this to the historical daily

Strangle Implied Daily Volatility Calculator volatility (HDV) of HPQ for 2 years,
one year, 90 day and 30 day, using a
Stock Symbol: HPQ Interest rate: model like the one we developed in
Stock Price: 29.640 0.010
CALL PUT
HW1
HW1.
Month: Mar Mar
Strike: 30.00 29.00 If the IDV in the model to the right is
Expiration: 3/22/14 3/22/14 substantially higher than the HDV then
Price: 1.130 1.110
the
h option
i isi “priced
“ i d high,”
hi h ” andd not a
Days to maturity: 24 24 good candidate for any kind of long
DTM override: 32 32 position, but may be ideal for a short
pposition like an iron condor or writingg
Implied daily volatility: 0.01919 0.02146
One-day time decay: 0.020 0.021 covered calls.
Version 3.3 August 16, 2011

Calculate
Reading the Options Chain
IBM's stock info
Out of the
Money

Expiration
p In the Bid/Ask
date St ik Prices
Strike Pi
Money same as
stocks

Out of the In the

Source: Volume & Open Interest
Money Money
Reading … (blowup from previous page)

You can buy the IBM November 19 195 You can buy the IBM November 19 175
Call for $1.82 (OOM), which gives you Put for $8.05 (ITM), which gives you
the right to buy IBM for $195 per share the right to sell IBM for $175 per share
between now and Nov 19. between now and Nov 19.

Note: These examples assume purchases at Best Ask.

Obviously you can submit a limit order at any price.

Note the big Bid/Ask – the less the liquidity the bigger
Source: these spreads.
 Potential Call Option Values
(upon expiration)
$12.00

This shows only what the option

$10 00
$10.00
will
ill be
b worthh if held
h ld to expiration,
i i
given the possible prices of IBM.
$8.00

$6.00 This
hi is
i the
h Nov 19 (exp)
( ) IBM OOM
195 Call, purchased at $1.82 (BA)
$4.00 on Sep 29, when IBM was $177.62
(last)
(last).
$2.00

$0.00

This is a bet that the

‐$2.00
stock price will rise.
‐$4
$4.00
00
175 180 185 190 195 200 205

Profit/Loss Gross value
The all
all--important p
premium
remium on OTM options
The premium for an in-the-money option
converges to zero as the option
approaches expiration.

The
h premium
i off an out-of-the-money
f h option
i can be b thought
h h off as simply
i l
the price of the option because the option has an intrinsic value of 0 at the
moment.

The premium for either is a function of

1. Time to maturity (shorter is smaller) – time decay
2. The underlying stock's volatility (greater is larger)
3. The degree to which the option is in the money (more is smaller)
 Issue 1: Time Decay
1.60
This shows the actual projected time decay of a
March 75 DIA call option, purchased for $1.51,
1.40 when DIA was trading at $72.15 (implied daily
volatility
l tilit att 0.0156),
0 0156) calculated
l l t d using
i an option
ti
1.20 calculator. This assumes no change in DIA price
and no change in volatility.
1 00
1.00

0.80

0.60

0.40

0.20

0.00
33 32 31 30 29 28 27 26 25 24 23 22 21 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1
 Issue 2: The Impact
p of Volatility
y
Put Option Price Calculator 3.50
Daily Volatility
3 00
3.00
Stock symbol: TLT
Put option: Oct 106 2.50
Date Today: 8/25/2010
Expiration Date: 10/16/2010 2.00
DTM: 52
1.50
Stock Price: 108.14
Strike Price: 106.00
Daily Volatility: 0.0117 1.00
Interest Rate: 0.010
Ti
Time: 52 0 50
0.50

d1 Numerator: 0.02142 0.00

Duration Volatility: 0.08437
N(-d1): 0.3998
N(-d2):
( ) 0.4327

Option Price: 2.57

Option Premium: 2.57
Scenario: 20 days have passed, leaving 32, no
change
g in pprice,, so the ggraph
p above shows the
Note: This is mapped in TLT Volatility in
Finance>Volatility Calcs
sensitivity to volatility alone.
(Old slide from the
glory days)
Issue 3: Distance
The premium on an option is Spread
determined by the three components 10/9/08
DIA at 91
91.55
55 Closer is
listed on the last slide, (1) the DIA Nov Call Ask greater
volatility of the stock and the market Strike Ask Premium
75 17.10 0.55
in general, (2) spread from the strike
80 12.25 0.70
price
i (whether
( h h in i the
h money or out),
) 90 4.45 2.90
and, (3) especially for out-of-the-
money options, the time before the Time
option expires.
expires More
9-Oct-08 distant is
It is possible to segregate these three in DIA at 91.55 greater

theory and empirically and the ability DIA 94 Call Ask

Oct 2 37
2.37
to do so is essential for advanced
Nov 5.10
options trades. Dec 5.90
Advice: Design
g and use yyour own Mar 7.60
models!!
Note: Premiums were unusually high in Oct
08 because of volatility in the markets.
Strategy 1: Leveraging Long with a IWM Econ 104
strategies
Deep--in
Deep in--the
the--Money (DITM) rolling call
The IWM ETF tracks the Russell
2000 and trades at 10%.

Buy this one

Source: TD Ameritrade The call option that you buy must have adequate
Option Chains, Oct. 6, 2011 open interest (at least a few hundred contracts).
Complex Strategy 2: Strangles

You can buy the IBM November 19 195 You can buy the IBM November 19 175
Call for $1.82 (OOM), which gives you Put for $8.05 (ITM), which gives you
the right to buy IBM for $195 per share the right to sell IBM for $175 per share
between now and Nov 19. between now and Nov 19.

Do you remember
D b ththese from
f th
the last
l t lecture?
l t ? If we
do both it is a strangle!
Source:
 Performance and Profitabilityy of the Strangle
g
$20.00 Note: This graph is somewhat misleading. It show the profit and
value of the position on the expiration date only if the option is
$15 00
$15.00
held to expiration. It shows nothing about the possible value of an
option between now and the expiration date.

$10.00

P fi
Profit Profit
$5.00

$0.00

Loss
‐$5.00 Clearly y yyou are
playing volatility
‐$10.00 here. This example is
a little asymmetric.
‐$15.00
150 155 160 165 170 175 180 185 190 195 200 205 210 215 220
We did this in Econ 136 in 2007.

Complex Strategy 3: Goldcorp GG Hedged

Covered Call (Collar)

• When you write an OTM call and buy an OTM put

((for insurance)) this is called a Collar.
• Goldcorp is $21.50
• Nov 22.50 call option
p is $$1.25
• Nov 17.50 put option is $0.25
• Buy the stock
• Write the call
• Buy the put (for insurance)
Complex Strategy 4:
Writing
g covered calls ....

This above is a covered call I wrote specifically for this class last year. I
bought AeroVironment (AVAV) last Spring for an Econ 136 experiment
for around 26. I should have sold it when it popped above 35 but didn’t.
So I wrote this call for us to track until November 22.

Because of high volatility this was expensive for the buyer. I pocket
$1.50 per share and would actually prefer that this be exercised, allowing
me to
t also
l pocketk t a $4 cap gain
i ($1.41
($1 41 had
h d I bought
b ht the
th stock
t k then
th written
itt
the call). The $2.91 gain if executed is more than 10% absolute – not bad
for 50 days. If it doesn’t execute I will just write another call.

Note: This option was exercised.

 Strategy 6: The Iron Condor
The primary
Th i bet
b t was This is a cash
cash-positive
positive bet
2.00
writing a strangle on low (and lower)
consisting of a 132 call volatility. You are net cash
1.50 positive and want to stay
for $1.25 and a 128 put
f $1
for $1.64
64 when
h DIA was that way.
way
1.00 at $130.36.

0.50

0.00

-0.50

-1.00

Lower floor provided Upper floor provided

-1.50
1 50 by 124 Long Put, by 135 Long Call,
which cost $0.80. which cost $0.35.
-2.00
Possible Prices of DIA on Mayy 19, 2012
-2.50
122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137
 Strategy
gy 7: Butterflyy spreads
p ((call))
Betting on no or little price movement: (1) Buy one ITM call, (2) buy one OTM call, (3)
write two ATM calls. This is done normallyy for near-term expiration
p dates.

SPY: 187.44

W: 2 187 for
2.02

B: 1 184 for
4.21

B: 1 191 for
0 39
0.39.

Net: $1.80

Exam 2 question: When would you use this strategy and what role is played by
each leg??
 Butterfly (Call) payoff grid
4.00
SPY Butterfly 3/4/14
SPY stock 187.44
Mar 184 Call 4.21 Buy
3.00
Mar 187 Call 2.02 Write 2X
Mar 191 Call 0.39 Buy
Net -0.56
2.00

1.00

0.00

-1.00

-2.00
180 181 182 183 184 185 186 187 188 189 190 191 192 193
Net Gross
 Butterfly (Put) payoff grid
5.00 SPY Put Butterfly 3/4/14
On a butterfly, it doesn’t SPY stock 187.44
much matter whether you Mar 184 Put 1.06 Buy
4.00 Mar 187 Put 2.06 Write 2X
use calls or puts,
puts payoff
Mar 191 Put 4.72 Buy
format is about the same.
Net -1.66
3.00

2.00

1.00

0.00

-1.00

-2.00
180 181 182 183 184 185 186 187 188 189 190 191 192 193 194 195
Net Gross
 What you must do in HW4/5
STRIKE PRICE PROBABILITY
CALCULATOR Time is frozen to March 4, 2014, 8:52 AM.
Analyst'ss Name:
Analyst Name:
At that moment SPY is tradingg for 187.410.
 
Date Today:   3/14/14 You have bought a March 22 Call option
Stock
Strike Price 190 at Best Ask for $0.63.
Stock Symbol:  SPY
Stock Price:   187.410 There are 8 days to expiration
expiration.
Option
Option Strike Price:  190 You are to use the one-year historical
Option Expiration Date:  3/22/14
Option Price (Best Ask): 
p ( ) 0.630 volatility from HW1 to calculate:
Days to expiration:  8
Historical Data (1) The probability that the stock price will
Log Growth Rate Price to Strike 
Price:   
be higher than the strike price at
Sample Mean Daily Growth Rate:
Sample Mean Daily Growth Rate:  0 000000
0.000000 expiration assuming a zero alpha,
alpha and
Sample Daily Standard Deviation:    (2) The probability that the stock price will
Time‐adjusted Standard Deviation:   
Calculation
be higher than the strike price at your
Probability of Stock Price Greater  estimated alpha (which may produce the
than Strike Price at Expiration:  same result).
l)
25.00 1.20 When you ask the question, “What is
The NormBase file ... the prob that price will go from 100
1.00
20 00
20.00 to 105?
105?”, you are also asking “How
How
0.80 many standard deviations is 105
15.00
away from 100, and what is the
0.60
probability of that?”
10 00
10.00
0.40
Ranges Mean to Value Cumulative Probs
+/- 3 0.9973 0.4987 -0.0400 -2 0.0228
5.00
0.20 +/- 2 0.9545 0.4772 -0.0200 -1 0.1587
+/-1.5 0.8664 0.4332 0.0000 0 0.5000
+/-1
+/ 1 0 6827
0.6827 0 3413 0.0200
0.3413 0 0200 1 0 8413
0.8413
0.00 0.00
-0.08 -0.06 -0.04 -0.02 0 0.02 0.04 0.06 0.08
+/-0.5 0.3829 0.1915 0.0600 2 0.9772

9.00 We transform 1.20 Value Cumulative Probs

8.00
90 4837
90.4837 -2
2 0.022750
0 022750
1.00 95.1229 -1 0.158655
7.00
100.0000 0 0.500000
6.00 0.80
105.1271 1 0.841345
5.00 110 5171
110.5171 2 0.977250
0 977250
0.60
4.00

3.00 0.40
Probability of X
2.00 105 is 0.164581
0 20
0.20
greater than:
1.00

0.00 0.00
82 85 88 91 94 97 100 103 106 109 112 115 118 121 Helpful to understand ....
 Name: Gary R. Evans
Date: March 4, 2014
... a small segment of my Visual Basic
code.
Strangle Implied Daily Volatility Calculator

Stock Symbol: HPQ Interest rate:

Stock Price: 29.640
CALL PUT
0.010
Where we are going ... the
Month:
Strike:
Mar
30.00
Mar
29.00
actual strangle calculator
Expiration:
Price:
3/22/14
1.130
3/22/14
1.110
that we used two weeks
Days to maturity: 18 18
ago.
DTM override: 32 32

Implied daily volatility: 0.01919 0.02146

One-day time decay: 0.020 0.021
Version 3.3 August 16, 2011

Calculate