Volatility & Arbitrage Trading ' 2002 Market Compass, Inc. www.marketcompass.com Volatility & Arbitrage Trading Options involve risk and are not suitable for everyone. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies may be obtained from your broker, one of the exchanges, or The Options Clearing Corporation. Examples that are covered in this manual or discussed through out the course do not take into consideration commissions and other transaction fees, tax considerations, or margin requirements, which are factors that may affect the economic outcome of any investment strategy. Any strategies or examples covered in this manual or discussed during the presentation, including actual securities and price data, are strictly for illustrative and educational purposes and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities of any type. An investor should review transaction costs, margin requirements, and tax considerations with his broker and tax advisor before entering into any options strategy. Copyright  1999-2000 Market Compass LLC. All rights reserved. This material may not be reproduced, either wholly or in part, without the written consent of Market Compass. ' 2002 Market Compass, Inc. 2 www.marketcompass.com Volatility & Arbitrage Trading Arbitrage (Options Pricing) ' 2002 Market Compass, Inc. 3 www.marketcompass.com Volatility & Arbitrage Trading The Building Blocks By now the reader should be familiar with the risk / reward characteristics of six fundamental positions: (cid:1)(cid:2)Long Stock (cid:1)(cid:2)Short Stock (cid:1)(cid:2)Long Call (cid:1)(cid:2)Short Call (cid:1)(cid:2)Long Put (cid:1)(cid:2)Short Put Rather than looking at each of the above positions as independent strategies, the reader should now look at them as building blocks. Used in combination, these building blocks can create a variety of strategies to addresses any market sentiment. The process of combining these building blocks is called the creation of Synthetics. For example, assume XYZ is trading at $50 and the July 50 XYZ calls and puts are each trading at $2. Compare the following P/L graphs: Purchasing 1 July 50 call P&L Graph 700.00 600.00 500.00 400.00 ofit 300.00 r P s - 200.00 s o 100.00 L 0.00 -100.00 -200.00 -300.00 42.00 44.00 46.00 48.00 50.00 52.00 54.00 56.00 58.00 Stock Price Purchasing 100 shares of stock and 1 July 50 put. ' 2002 Market Compass, Inc. 4 www.marketcompass.com Volatility & Arbitrage Trading P&L Graph 700.00 600.00 500.00 400.00 ofit 300.00 r P s - 200.00 s o 100.00 L 0.00 -100.00 -200.00 -300.00 42.00 44.00 46.00 48.00 50.00 52.00 54.00 56.00 58.00 Stock Price Notice how the graphs are identical; is this a coincidence? We know that the outright purchase of the call will cost us $200 (2 X100). We also know that purchasing the $50 level put will offset any downside that we have in the stock, therefore if purchase stock for $50/share our p/l graph will be identical to that of a 50 level call. However, the married put transaction is a much bigger capital commitment. The trader might be better off purchasing the call as it will provide him with leverage; he can put the position on many more times for the same amount of capital committed. Now consider the consequences of purchasing 1 July 50 call and selling 1 July 50 put. Because the prices of the call and put offset each other, there is no net cost to putting on this position. At expiration, if the stock is trading above $50 you will exercise the option and then purchase 100 shares of XYZ at a net cost of $50/share. I the stock closes below $50, the holder of the put will exercise and you will be assigned, thus purchasing 100 shares of stock for $50/share. In either event, you will end up owning 100 shares of XYZ for $50/share. ' 2002 Market Compass, Inc. 5 www.marketcompass.com Volatility & Arbitrage Trading P&L Graph 1,000.00 800.00 600.00 400.00 ofit 200.00 r P s - 0.00 s o -200.00 L -400.00 -600.00 -800.00 -1,000.00 42.00 44.00 46.00 48.00 50.00 52.00 54.00 56.00 58.00 Stock Price Importance of Understanding Synthetics Being able to identify synthetics and understanding the synthetic relationships between all options on a trading screen creates many advantages for the trader. Most notably, this understanding of synthetics provides: (cid:1)(cid:2)Techniques for arbitraging building blocks; scalping of options or stock by taking advantage of discrepancies in pricing (cid:1)(cid:2)Alternatives for building, or legging, into positions (cid:1)(cid:2)Strategies for either buying or selling options that might otherwise be difficult to execute due to market liquidity or slippage (cid:1)(cid:2)Techniques for identifying pricing discrepancies, or skews, that exist in the marketplace (cid:1)(cid:2)Ways to appraise the true market value of any single building block (cid:1)(cid:2)Methods for calculating options pricing (cid:1)(cid:2) An understanding of the risk inherent in any market position (cid:1)(cid:2)Alternatives for closing out or neutralizing risk in market positions ' 2002 Market Compass, Inc. 6 www.marketcompass.com Volatility & Arbitrage Trading Practical Applications Although synthetics are used extensively by professional traders and institutions as vehicles for arbitrage (the first item on the list), it is impractical for most off-floor or Reg.-T traders to attempt to utilize them in this way. Execution and carrying costs, compounded by slippage, makes straightforward arbitrage (I.e. reversals and conversions) extremely difficult. The reader of this text would be better served by focusing on each strategy and synthetic concept introduced as a means for understanding options pricing, factors that may be affecting that pricing, and alternatives for alleviating market risk. For example, a trader has purchased 1000 shares of MSFT for 68.70 and then that he has eliminated directional risk in a long stock position by selling a call will see the following graph: P & L Graph 2,000.00 1,000.00 0.00 -1,000.00 ofit-2,000.00 Pr s / -3,000.00 s Lo-4,000.00 -5,000.00 -6,000.00 -7,000.00 -8,000.00 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 Share Price The trader would be surprised to see that selling the call has only provided him with a downside buffer; it did not alleviate or eliminate his risk. Furthermore, if the trader had an understanding of synthetics he would see that selling calls against a long stock position has created a synthetic short; a position best avoided in a bear market. Should I Use the Synthetic or the Actual? Recall the married put example from the previous page; the trader might be better off purchasing the call rather than the ' 2002 Market Compass, Inc. 7 www.marketcompass.com Volatility & Arbitrage Trading married put. This tends to be true in most cases. Exception to this principle may be situations already discussed: skew, volatility, slippage. In these cases it might actually be better to use the synthetic equivalent. Another disadvantage of using the actual option is that it eventually expires. A trader that has a longer-term bullish sentiment on a stock might not want to try purchasing a call every month. Net transaction costs aside, purchasing the stock and put as needed might better meet his objective. The Six Synthetics The following examples illustrate the relationship between calls, puts and stock. There are six stock/options combinations, which result in (cid:147)synthetic positions.(cid:148) Note that in each formula, each call and put has the same strike price and expiration. Synthetic Combination Long Long Call w/ Short Put Stock Short Short Call w/ Long Put Stock Long Long Put w/ Long Stock Call Short Short Put w/ Short Stock Call Long Long Call w/ Short Stock Put Short Short Call w/ Long Stock Put ' 2002 Market Compass, Inc. 8 www.marketcompass.com Volatility & Arbitrage Trading Pricing Synthetics We now have two different ways to acquire a building block: we can purchase or sell the building block directly, or we can purchase or sell it synthetically. In order to determine the price at which we would be creating the synthetic position, we must have the following pieces of information: • Current stock price • Option strike price • Days to option expiration • Dividend payment dates and amounts (If applicable) • Applicable interest rates (Risk Free Rate) to calculate Cost of Carry Once all of the above variables are determined, including the Cost of Carry, calculating the price of the synthetics then simply becomes a process of using these formulas: Synthetic Pricing Formulas (cid:1)(cid:2)Synthetic Call Price (Put Price + Stock Price + Cost to Carry) (cid:150) Strike Price (cid:1)(cid:2)Synthetic Put Price (Call Price + Strike Price (cid:150) Cost to Carry) (cid:150) Stock Price (cid:1)(cid:2)Synthetic Stock Price (Call Price – Put Price) + Strike Price Cost of Carry Most traders, including professional traders, will borrow (or collect in the case of shorting) money to establish their market positions. The cost of borrowing or receiving money associated with carrying a position is called the Cost of Carry. Specifically, it is the interest paid (received) on a position which debits (credits) a trading account. When stock and/or options are purchased the trader will pay interest to the clearing firm for using their funds; similar to borrowing on margin for retail or Reg. T. traders. When stocks and/or options are sold, the account is credited and the trader will receive interest on the credit balance to his account. Even in instances where the trader may be trading in a cash account, cost of carry must be calculated to reconcile for opportunity cost. ' 2002 Market Compass, Inc. 9 www.marketcompass.com Volatility & Arbitrage Trading Formula : Cost of Carry Interest Rate x Strike Price x Days to Expiration / 360 (cid:1)(cid:1)(cid:1)(cid:1)(cid:2)(cid:2)(cid:2)(cid:2) Which interest rate should be used to calculate cost of carry? Determining Your Cost for the Synthetic – Your % Rate (cid:1)(cid:2) Retail and Reg. T traders receive different rates than professional traders; this rate is usually higher than professional broker/dealer rates and varies from brokerage to brokerage. When calculating the price at which you(cid:146)d be creating a synthetic, use your specific long or short rate. When you are executing a trade on margin (borrowing funds), you will use a long rate. Shorting transactions, where you(cid:146)re taking a credit into your account, should be calculated using the short rate. Like a loan vs. a savings account, the brokerage creates a (cid:147)spread,(cid:148) between borrowing and lending. Consult your brokerages for more information regarding individual interest rates. Comparing Options Values; Pricing Alignment – Broker Call Rate (cid:1)(cid:2) Mispricings, or skews, are more easily spotted by looking at implied volatility information. However, in instances where an off-floor trader is trying to determine the reasons why on- floor traders are making a particular market, the price actual options must be compared to their synthetic equivalents. (cid:1)(cid:2) Bids and offers reflected in an options chain are made in the trading pits by traders whose function it is to provide liquidity; hence the name Market Maker. These Market Makers make markets based on their transactions cost, including their cost of carry. Market making requires a significant amount of capital deployment and risk. To assist in their function of providing liquidity in the market place, market makers are extended special margin privileges, and at a reduced interest rate. Although, these rates vary from one Market Maker to another, they tend to be close to the Broker Call Rate. When calculating synthetics that involve a long cost of carry, add about ‰ point to the Broker Call; when calculating a short interest, subtract about ‰ point. ' 2002 Market Compass, Inc. 10 www.marketcompass.com