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Single Stock Option’s Seminar Part I Option Trading Overview By Steve D. Chang Morgan Single Stock Option’s Seminar Part I Option Trading Overview By Steve D. Chang Morgan Stanley Dean Witter Part II Volatility Trading Concept and Application By Charles Chiang Reference (apr 02) Deutsche Bank A. G.

Volatility Trading Concept and Application By Charles Chiang Vice President, GED Trading, Deutsche Bank Volatility Trading Concept and Application By Charles Chiang Vice President, GED Trading, Deutsche Bank Reference (apr 02)

3 Index 1. Option Trading Strategies 2. What Is Volatility? 3. Volatility and Option 3 Index 1. Option Trading Strategies 2. What Is Volatility? 3. Volatility and Option Pricing 4. Delta-Neutral Strategy 5. Case Study 1 6. Case Study 2 7. Risks in Volatility Trading 8. Application of Option Volatility Trading 1. Option Risk Management 2. Equity Derivative Structured Product n Summary and Appendix (introduction on Deutsche Bank A. G. ) Reference (apr 02)

4 Option Trading Strategy n Leverage Trading / Directional Trading Strategy – buy call, 4 Option Trading Strategy n Leverage Trading / Directional Trading Strategy – buy call, sell put, call spread, etc – buy put, sell call, put spread, etc Take a view on the market direction n Volatility Trading Strategy Take a view on the market volatility Reference (apr 02)

5 What Is Volatility? n A measure of the degree of the fluctuations n 5 What Is Volatility? n A measure of the degree of the fluctuations n For example, compare the two listed companies in Taiwan – TSMC (ticker: 2330) – Chung Hwa (ticker: 2412) Reference (apr 02) Intuitively, which one do you think is more volatile?

6 What Is Volatility? Volatility in statistical language – Annual volatility – Daily volatility 6 What Is Volatility? Volatility in statistical language – Annual volatility – Daily volatility 2330 Reference (apr 02) 2412

7 Volatility and Option Pricing n Option price is influenced by – Underlying Stock 7 Volatility and Option Pricing n Option price is influenced by – Underlying Stock Price – Strike price – Maturity – Interest rate – Dividend – Volatility n Assume that all the other factors are equal, will you pay the same price for the option written on TSMC and Chung Hwa? Reference (apr 02)

8 Volatility and Option Pricing n The price of a call option increases when 8 Volatility and Option Pricing n The price of a call option increases when the underlying stock becomes more volatile. – From buyers’ point of view, higher volatility means More chances to expire in the money; – From issuers’ point of view , higher volatility means Higher hedging cost n Two types of volatility – implied volatility Market Value of Option Pricing Model Implied Volatility Actual Volatility Option Pricing Model Fair Value of Option – actual volatility Reference (apr 02)

9 Delta-Neutral Strategy n Delta-neutral is the position where n In a Delta-neutral position, 9 Delta-Neutral Strategy n Delta-neutral is the position where n In a Delta-neutral position, small changes in stock price will not change the value of the stock-option portfolio. – An example Reference (apr 02)

10 Case Study 1 1. Buy 1, 000 call option on TSMC. Assume that 10 Case Study 1 1. Buy 1, 000 call option on TSMC. Assume that 1. European style, expire in two months; 2. Sold at the money; 3. One option exchanged for one share; 4. Interest rate r=2%p. a. ; 5. No dividend will be paid; 6. actual annual volatility σY= 38%. 2. Sell underlying stock to keep the portfolio Delta-neutral by rehedging it from time to time. Reference (apr 02)

11 Case Study 1 n The benchmark for rehedging decision is σD= 2. 4%, 11 Case Study 1 n The benchmark for rehedging decision is σD= 2. 4%, which means Daily change of stock price < 2. 4% Enjoy a leisure day Daily change of stock price 2. 4% Adjust the stock position to achieve Delta-neutral n In our example, altogethere are 10 rehedges during the twomonths’ life of the call option Reference (apr 02)

12 Case Study 1 n When σY=38%, 48% and 28%, the outcomes of this 12 Case Study 1 n When σY=38%, 48% and 28%, the outcomes of this strategy are: Fair Price n When an investor buy an option whose implied volatility is lower than its actual one, he makes money no matter to which direction the market moves ! Reference (apr 02)

13 Case Study 2 1. Now consider buying 1, 000 options on Chunghwa and 13 Case Study 2 1. Now consider buying 1, 000 options on Chunghwa and short sell the underlying stock to hedge. Assume that all factors are the same as in the example of TSMC, except that actual annualised volatility is 25%. 2. when σY=25%, 35% and 15%, the results are as followed: Fair Price Reference (apr 02)

14 Case Study 2 n Please note that the price for options written on 14 Case Study 2 n Please note that the price for options written on Chung Hwa is relatively cheaper than that on TSMC (i. e. the former has a lower percentage price). Fair Price n This is because the volatility of TSMC’s stock is higher than that of Chung Hwa’s. Reference (apr 02)

15 Risks in Volatility Trading n Volatility trading strategy may be subjected to potential 15 Risks in Volatility Trading n Volatility trading strategy may be subjected to potential loss if the writer/buyer of option estimates the market volatility incorrectly. – A single shock to stock price (e. g. 911 event, corporate action etc, whether positive or negative, may lead to great increase/decrease of the actual volatility of the underlying stock – The daily up and down limit on underlying stock may obstruct timely rehedging and other friction in the underlying market (transaction cost, bid/offer spread, liquidity) – Option model assumptions – Regulatory risks such as foreign ownership limit, short selling restriction Reference (apr 02)

16 Application of Option Volatility Trading (1) Option Risk Management 1. Market makers usually 16 Application of Option Volatility Trading (1) Option Risk Management 1. Market makers usually reduce optionality risks by buying/selling options of same/different strike, maturity and hedge the net delta position between different options. For example 1. Option portfolio may consist of three parts: 1. Short call with higher implied volatility(CH) 2. Long call with lower implied volatility(CL) 3. Long underlying stock 2. The premium of CL eats up part of their profit 3. When market volatility moves up unexpectedly, the profit in CL partially offset the loss in CH Reference (apr 02)

17 Application of Option Volatility Trading (1) Option Risk Management — Examples 1. Covered 17 Application of Option Volatility Trading (1) Option Risk Management — Examples 1. Covered warrant risk management - buy short term single stock options to cover gamma risks in the warrant book 2. Index option volatility vs. single stock volatility - hedging or arbitrage between single stock volatility and index volatility 3. CB volatility vs. single stock option volatility - take advantage on volatility differential between implied volatility from CB and single stock options Reference (apr 02)

18 Application of Option Volatility Trading (2) Equity Derivative Structured Products n One common 18 Application of Option Volatility Trading (2) Equity Derivative Structured Products n One common example of equity derivative structured product is Equity Linked Note (ELN). n Most popular examples are: – Principal Guaranteed Notes – High Yield Notes (HYN) Bond + Equity Derivatives Structure: Bull/Bear/Range Underlying: Stock/Basket/Index Reference (apr 02) = Equity Linked Note Return: Coupon/Redemption (fixed or dependent on underlying performance)

19 Equity Derivative Structured Products Principle Guaranteed Notes n Considerations: U/L, participation, protected portion 19 Equity Derivative Structured Products Principle Guaranteed Notes n Considerations: U/L, participation, protected portion n Structure: Investor + note + options n Pricing: participation = (unprotected portion + interest) / option value n Types: Reference (apr 02) range / bull / bear

20 Equity Derivative Structured Products Principle Guaranteed Notes — Example 1 U/Ls: Tenor: Options: 20 Equity Derivative Structured Products Principle Guaranteed Notes — Example 1 U/Ls: Tenor: Options: Notes: Protection: Issue price: Participation: Redemption: TSMC 1/2 year on notes + 100~110 call spread + zero coupon note 97% 100% of the appreciation of U/L on maturity, if * appreciation of U/L < 100%, redemption will be 97% * 100% <= appreciation of U/L < 110%, redemption will be 97% + appreciation of U/L * appreciation of U/L >= 110%, redemption will be 97% + 10% Reference (apr 02)

21 Equity Derivative Structured Products Principle Guaranteed Notes — Example 2 U/Ls: Tenor: Options: 21 Equity Derivative Structured Products Principle Guaranteed Notes — Example 2 U/Ls: Tenor: Options: Notes: Protection: Issue price: Participation: Redemption: TSMC 1/2 year on notes + 100~110 call spread + zero coupon note 94% 100% of the appreciation of U/L on maturity, if * appreciation of U/L < 100%, redemption will be 94% * 100% <= appreciation of U/L < 110%, redemption will be 94% + appreciation of U/L * appreciation of U/L >= 110%, redemption will be 94% + 10% n The difference in protection rate above indicates a different implied volatility in the embedded call options Reference (apr 02)

22 Equity Derivative Structured Products High Yield Notes n Considerations: U/L, issue price, annual 22 Equity Derivative Structured Products High Yield Notes n Considerations: U/L, issue price, annual yield n Structure: Investor + note - options n Pricing: issue price = PV(par) - option value n Types: bull / bear / range Reference (apr 02)

23 Equity Derivative Structured Products High Yield Notes — Example U/Ls: TSMC at $78. 23 Equity Derivative Structured Products High Yield Notes — Example U/Ls: TSMC at $78. 64 Tenor: 60 days on notes Options: - 90% put, strike at $ 70. 78 Notes: + zero coupon note Issue price: 98% of par Ann. Yield: 12. 2% Redemption: on maturity, if * U/L close >= 90%, redemption will be at 100% of par * U/L close < 90%, redemption will be the stock price on maturity / $70. 78 Reference (apr 02)

24 Summary Volatility trading concept and application n Making profit without taking directional view 24 Summary Volatility trading concept and application n Making profit without taking directional view but view on market volatility through delta-neutral strategy. (Provided that short selling facility on the underlying is possible) n Hedging option portfolio – volatility risk (Gamma and Vega risk) – liquidity risk (the discontinuous movement of stock price) n Equity derivatives structured product – combining equity options and fixed income securities whose feature depends on options premium paid/ sold Reference (apr 02)