• Equity Options Online Course November 2011

  • JSE Equity Options: Introduction

    JSE 5 Markets

    • Equity Market
    • Equity Derivative Market
    • Commodity Derivative Market
    • Currency Derivative Market
    • Interest Rate Market

    Derivatives
    • A financial instrument that derives its value from the value or return of another asset.

    The two main types of derivatives at the JSE are:
    • Futures
    • Options

  • JSE Equity Options: Introduction

    JSE Options are based on following underlying assets:

    • Equities
    • Commodities
    • Bonds
    • Currency
    • Interest Rates

    This presentation focuses on JSE Equity Options but the concept is the same for options based on any of the underlying assets traded on the JSE which are listed above.

  • JSE Equity Options: Futures Refresher

    JSE Options are based on Futures contracts

    Future

    • An agreement between two parties to buy/sell an asset at a certain time in the future for a predetermined price.

    Contract sizes (nominal) standardised:
    • 1 Single Stocks Future = 100 Shares (IDX 1 to 1)
    • 1 Index Future = R10 per point movement

    Contracts expire every 3rd Thursday of March, June, September and December Allowed to sell short Profits and losses calculated on a daily Zero Sum Game 

    For every winner there’s a loser Risk mitigated by way of Initial Margin:
    • Covers exchange against default
    • Worst possible loss in 1 days movement
    • Returned with interest
    • Approximately 10% - 20% of underlying exposure

  • JSE Equity Options: Futures Example - Share Price Increase

    JSE Equity Options: Futures Example – Share Price increase 

    Physically settled Futures – On Futures Close Out (FCO) the buyer will buy the physical share from the seller at the closeout price (R120), reporting it to TradElect with trade type OX

    Adding the R10 profit made he only paid R110 for the share as originally agreed

  • JSE Equity Options: Options Defined

    An option provides the holder the right (not obligation) to buy (call) or sell (put) a specified quantity of an underlying asset at a predetermined price at or before the expiration of the option.

    Call Option Analogy: Imagine you want to buy a house but you’re not sure. You can buy an option from the seller to purchase the house at a certain price at a specified date in the future. When you get to the future date and house prices have gone up, you will be able to buy the house at the original price.

    Put Option Analogy: You’ve got insurance on your house, you should consider insurance on your share portfolio. If your house burns down, your insurance company will pay out the insured value of the house. For this insurance you’ll have to pay a premium.

    Four possible Option positions:

    • Long Call – Has the right to buy
    • Short Call – Has the obligation to sell
    • Long Put – Has the right to sell
    • Short Put – Has the obligation to buy

  • JSE Equity Options: Options Priced

    Shares trade at a price

    Futures trade at a price

    An Option’s price is called the Premium (time you’re buying)

    Variables used in determining the premium:

    • Strike Price – Future Buy/Sell Price
    • Underlying Price – Current Share/Futures Price
    • Interest Rate
    • Dividend Yield
    • Expiry Date
    • Option Type (Call or Put)
    • Volatility
    • We use the Black & Scholes model to calculate your premium

  • JSE Equity Options: Options - Technology

    American Style Options:
    • An option that can be exercised at any time prior to expiration is called an American option

    European Style Options:
    • An option that can only be exercised at expiration is called an European option


    JSE makes use of both American and European Style Options 

    In the money:
    • You will exercise the option

    Out the money:
    • You will abandon the option

    At the money:
    • Strike Price = Underlying Price

  • JSE Equity Options: Call Option - Example

    You don’t have shares in a company but think this dynamic company is going to do well in the future (e.g. new CEO with great vision)

    The company is currently trading at R100

    You buy a call option with a strike price the same as it’s current price (R100) at a premium of R12.

    Scenario 1 – Company performed well!

    • On future date the company is trading @ R120
    • Exercise your option and buy the shares @ R100 even though it’s trading at R120
    • Profit = R8 (R120 – R100 - R12)  

    Scenario 2 – Company did NOT perform well!

    • On future date the company is trading @ R90
    • Why would you exercise your option and buy the share at R100 if you can buy it at its current trading price of R90?
    • Loss = Premium of R12

  • JSE Equity Options: Put Option - Example

    You’ve got shares in in a company and want to protect yourself as you’re worried that this company is not going to do well in the future (e.g. new CEO with different vision)

    The company is currently trading at R200

    You buy a put option with a strike price of R200 at a premium of R20.

    Scenario 1 – Company did not perform well!

    • On future date the company is trading @ R160
    • Exercise your option and sell the shares @ R200 even though it’s trading at R160
    • Profit = R20 (R200 – R160 – R20)

    Scenario 2 – Company performed well!

    • On future date the company is trading @ R240
    • Why would you exercise your option and sell the share at R200 if you can sell it at its current trading price of R240?
    • Loss = Premium of R20 

  • JSE Equity Options: Why trade Options?

    Time to decide

    Protect the value of your shares (put)

    Leverage: small initial requirement can lead to high exposure  and profit potential.

    Option holder’s losses limited to premium

    Take advantage of unique opportunities:

    • Profit in volatile markets (Straddle and Strangle)
    • Can be combined with shares already owned to protect the value of your shares at very little cost (Fence)
    • Limiting both profit and loss (Collar)
    • Flexibility: Tailor-made to your needs 

  • JSE Equity Options: Options compared with common stocks

    Similarities

    • Both options and stocks are listed securities
    • Like stocks, options trade with buyers making bids and sellers making offers.
    • Option investors, like stock investors have the ability to follow price movements, trading volume etc. day by day or even minute by minute

    Differences

    • Price vs. Premium
    • Unlike common stock, an option has a limited life. Common stock can be held indefinitely, while every option has an expiration date
    • There is not a fixed number of options, as there is with common stock shares available
    • Stock owners have certain voting rights and rights to dividends (if any), option owners  participate only in the potential benefit of the stock’s price movement 

  • JSE Equity Options: Options compared with Warrants

    Similarities
    • Provides investors with same functionality, i.e. the right but not the obligation to buy or sell

    Differences
    • Options trades on SAFEX (Nutron), WR trades on Equity Spot market (TradElect)
    • Volatility transparent
    • Valued by an independent exchange
    • Issued by an exchange
    • Can short options
    • Options are fungible
    • JSE Trading cost
    §Options = 1 BP of exposure. WR = Fixed transaction cost
    §Contract will cost maximum 70 cents. 100 Shares will cost approximately R3.43

  • JSE Equity Options: In the Money Call Option Cash Flow - Example

    • JSE Options are in essence a future on a European style option
    • JSE revalues the option each night and you are margined just like a SSF contract except the prices are calculated with the modified Black formula
    • Example: Buy the right, but not the obligation to buy (long call) 1 future contract (100 shares) at the current future price (R100) in a year’s time. Share price goes up…
    JSE Equity Options: In the Money Call Option cash flow - Example

  • JSE Equity Options: In the Money Call Option cash flow - Example

    • On closeout the option holder (buyer) will exercise his option and as a result receive a future at the Strike Price of R100
    • That night the option holder is now a future holder and as a result will receive R2,000 (R20 * 100) variation margin (R120 - R100)
    JSE Equity Options: In the Money Call Option cash flow - Example
    • The next day he will go into the Equity spot market and pay R12,000 for the physical shares, i.e. R120 * 100 shares
    • His/her profit will therefore be the profit from the future - premium paid for option (R2,000 - R1,200) = Profit (R800)

  • JSE Equity Options: Reasons why it’s Suboptimal to exercise Future Style Options early

    • The biggest reason by far is that you're throwing away money. When you buy an option you're buying time value. By exercising early you're throwing away theta!
    • Portions of intrinsic value has already been cashed/received during live of the option
    • Additional initial margin is required for Futures position
    • Liquidity in the futures market is assumed to unwind futures position
    • Crossing a wide double in the futures market might cause loss of potential profits 

  • JSE Equity Options: Volatility introduction

    JSE Equity Options: Volatility Introduction

    Possibly the most powerful tool in finance is optionality-the right to choose

  • JSE Equity Options: Volatility

    • Volatility is the most important input- it is certainly the most subjective
    • This number is an estimate of the future- a projection of how risky it is to sell this particular insurance policy.
    • Let’s say you are insuring a building from theft.

  • JSE Equity Options: Volatility

    Are you insuring this house?

    JSE Equity Options: Volatility

  • JSE Equity Options: Volatility

    Or this house?
    JSE Equity Options: Volatility

  • JSE Equity Options: Volatility

    • Each night the JSE recalculate your margins-both initial and variation.
    • We use the modified Black formula for pricing options on futures. 

    Below is a change in value with zero stock price change but a 20% implied vol change- the option’s price has increased by 34.45%

    JSE Equity Options: Volatility

  • JSE Equity Options: Volatility

    In property, things change gradually- but in an equity market a stock can go from being a nice neighborhood to a slum in a matter of days- Just look at AIG. From 80 US dollars to just over one dollar and 11 cents on Friday the 20th March 2009.

    JSE Equity Options: Volatility

  • JSE Equity Options: Implied vs. Historic Volatility

    Historic volatility is a number derived from the price fluctuations of a stock. It is a factual number based on historical data.

    • Logarithm daily movement
    • Standard Deviation
    • Square root of days in year

    Implied volatility is the volatility measure “implied” from the prices that options are trading at in the market. It is strongly correlated with but often diverges from historical volatility.

    is the volatility measure “implied” from the prices that options are trading at in the market. It is strongly correlated with but often diverges from historical volatility.

  • JSE Equity Options: Implied vs. Historic Volatility

    JSE Equity Options: Implied vs. Historic Volatility 

  • JSE Equity Options: Implied vs. Historic Volatility

    JSE Equity Options: Implied vs. Historic Volatility 

  • JSE Equity Options: The Volatility Skew

    Options (on the same underlying with the same expiry date) with different strike prices trade at different volatilities - traders say volatilities are skewed when options of a given asset trade at increasing or decreasing levels of implied volatility as you move through the strikes.

    JSE Equity Options: The volatility skew

  • JSE Equity Options: Term structure of ATM Volatilities

    The at-the-money volatilities for different expiry dates are decreasing in time

    JSE Equity Options: Term structure of ATM volatilities

  • JSE Equity Options: The Volatility Surface

    Combining the previous two graphs leads to a 3D graph – the volatility surface

    JSE Equity Options: The volatility surface

  • JSE Equity Options: History of the volatility Skew

    • In 1972 Black & Scholes mentioned in their paper “the historical estimates of the variance include an attenuation bias – the spread of the estimated variance is larger than the true variance”
    • The first real observation of the skew pattern was mentioned in empirical work by Macbeth and Mervile in 1979
    • At that point in time it wasn't pronounced but the market crash of October 1987 changed all of that.
    • If one looks at option prices before and after October 1987, one will see a distinct break. Option prices begin to reflect an "option risk premium" - a crash premium that comes from the experiences traders had in October 1987.
    • After the crash the demand for protection rose and that lifted the prices for puts; especially out-the-money puts. To afford protection, investors would sell out-the-money calls. There is thus an over supply of right hand sided calls and demand for left hand sided puts - alas the skew.
    • In 1997 the authors of this highly praised paper were awarded the prestigious Nobel Prize

  • JSE Equity Options: Why is a skew necessary?

    The real phenomenon contributing to a volatility skew is either:

    • market imperfections systematically prevent prices from taking their true Black & Scholes values or;
    • the underlying asset price process differs from the lognormal diffusion process assumed by the Black & Scholes model. The term structure of volatility is thus the market’s way of mapping B&S to the real price process!

  • JSE Equity Options: Different markets

    Different markets have different skew shapes and thus different volatility dynamics

    JSE Equity Options: Different Markets

  • JSE Equity Options: Implied Volatility - Problem of Crenellations

    JSE Equity Options: Implied Volatility- Problem of crenellations 

  • JSE Equity Options: Implied Volatility- SAVI vs. ALSI ATM

    JSE Equity Options: Implied Volatility- SAVI vs. ALSI ATM 

  • JSE Equity Options: Volatility

    JSE Equity Options: Volatility 

  • JSE Equity Options: Volatility

    Post Nutron- from 18th August 2008 we introduced a compulsory modified Black formula that won’t let you trade without filling in the volatility- Now the reports look like this- we have accurate volatilities for all option trades.  

    JSE Equity Options: Volatility

  • JSE Equity Options: Crenellation solution – Single Stock Options – Customised application

    JSE Equity Options: Crenellation solution – Single Stock Options – Customised Application 

  • JSE Equity Options: Crenellation solution – Index Options – Sticky Strike Skew


    JSE Equity Options: Crenellation solution – Index Options – Sticky Strike Skew 

  • JSE Equity Options: MTM All.xls is a vital tool

    • All the methods we use to estimate market volatilities are put into the MTM All spreadsheet. /li>
    • This spreadsheet can be downloaded at: http://www.safex.co.za/pub/mtmdata/
    • You can use this spreadsheet to compare quoted volatility prices with the current mark to market level.

    JSE Equity Options: MTM All.xls is a vital tool

  • JSE Equity Options: Option Trading Strategies – Straddle Payoff

    JSE Equity Options: Option Trading Strategies – Straddle Payoff 

  • JSE Equity Options: Option Trading Strategies - Straddle

    JSE Equity Options: Option Trading Strategies - Straddle 

  • JSE Equity Options: Option Trading Strategies – Strangle Payoff

    JSE Equity Options: Option Trading Strategies – Strangle Payoff 

  • JSE Equity Options: Option Trading Strategies - Strangle

    JSE Equity Options: Option Trading Strategies - Strangle 

  • JSE Equity Options: Option Trading Strategies – Fence Payoff

    JSE Equity Options: Option Trading Strategies – Fence Payoff 

  • JSE Equity Options: Option Trading Strategies - Fence

    JSE Equity Options: Option Trading Strategies - Fence 

  • JSE Equity Options: Automated trading software - DDE Trader 

    • Free software. Dynamic Data Exchange (DDE) Future Trader already part of JSE’s Nutron Trading Front End
    • Upgrade plus DDE Options Trader to be deployed in 2010
    • In line with JSE’s long term plan to move on-screen…
    JSE Equity Options: Automated trading software - DDE Trader

  • JSE Equity Options: JSE’s Options Market - General discussions

    • Retail Options Feedback
    • Understanding / Education
    • Off-market vs. On-Market
    • Anonymous market
    • Maker-Taker incentive/reward fee model
    • Applying rules
    • Marketing

  • Questions & contact details

    Magnus de Wet


    James Boardman

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