Market Technicians Association - September 2016

Implied Volatility and VIX Russell Rhoads, CFA Director of Education – CBOE Options Institute

Disclaimer In order to simplify the computations, commissions have not been included in the examples used in these materials. Commission costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Multiple-leg strategies involve multiple commission charges. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Options involve risks and are not suitable for all investors. Prior to buying or selling an option, an investor must receive a copy of Characteristics and Risks of Standardized Options. Copies are available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois 60606. Investors considering options should consult their tax advisor as to how taxes may affect the outcome of contemplated options transactions. CBOE and Chicago Board Options Exchange are registered trademarks and The Options Institute is a servicemark of CBOE. All other trademarks and servicemarks are the property of their respective owners. This presentation should not be construed as an endorsement or an indication by CBOE of the value of any non-CBOE product or service described in this presentation. Copyright © 2016 Chicago Board Options Exchange, Incorporated. All rights reserved.

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Implied Volatility and VIX Outline Historical vs. Implied Volatility Put / Call Parity Single Day Implied Volatility CBOE Volatility Index Interpreting VIX Resources / Contact

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Historical vs. Implied Volatility Volatility Two Types of Volatility*

Historical Volatility – based on past stock price changes Implied Volatility – expected volatility based on option market pricing

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Historical vs. Implied Volatility Option Price Components Six Option Pricing Factors Price of Stock Option Strike Price Time Until Expiration Interest Rates

Dividends Implied Volatility

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Historical vs. Implied Volatility Pricing Calculator Inputs Price Strike Days to Exp. Dividends Interest Rate Volatility

51.00 50.00 30 1.95% 1.00% 25%

Output Theo Price

Call 1.90

Put 1.10

Where does this number come from?

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Historical vs. Implied Volatility Pricing Calculator Inputs Price Strike Days to Exp. Dividends Interest Rate Call Price

51.00 50.00 30 1.95% 1.00% 2.00

Output Volatility

30%

Implied volatility is determined by the market price of an option.

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Interpreting Implied Volatility As a Forecast Implied volatility may be taken as the market’s forecast of what would be a one-standard deviation move over the life of an option Basic Example XYZ at 100.00 IV of 1-year XYZ Options = 20% 1 Standard Deviation Move = +/-20 points

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Interpreting Implied Volatility The Bell Curve Standard Deviations Defined –

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Interpreting Implied Volatility Converting Implied Volatility Implied Volatility may be converted to a market price forecast 𝑺𝒕𝒐𝒄𝒌 𝑷𝒓𝒊𝒄𝒆 𝒙 𝑰𝒎𝒑𝒍𝒊𝒆𝒅 𝑽𝒐𝒍𝒂𝒕𝒊𝒍𝒊𝒕𝒚 𝒙 𝑫𝒂𝒚𝒔 𝒕𝒐 𝑬𝒙𝒑𝒊𝒓𝒂𝒕𝒊𝒐𝒏

𝑫𝒂𝒚𝒔 𝑷𝒆𝒓 𝒀𝒆𝒂𝒓 𝟏𝟎𝟎. 𝟎𝟎 𝒙 𝟎. 𝟒𝟎 𝒙 𝟑𝟓 ≈ 12.40 𝟑𝟔𝟓 Market expects underlying to be between up and down 12.40 at expiration with 68.2% certainty CBOE OPTIONS INSTITUTE

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Interpreting Implied Volatility Converting Implied Volatility On Day Implied Volatility Forecast 𝑺𝒕𝒐𝒄𝒌 𝑷𝒓𝒊𝒄𝒆 𝒙 𝑰𝒎𝒑𝒍𝒊𝒆𝒅 𝑽𝒐𝒍𝒂𝒕𝒊𝒍𝒊𝒕𝒚 𝒙 𝑫𝒂𝒚𝒔 𝒕𝒐 𝑬𝒙𝒑𝒊𝒓𝒂𝒕𝒊𝒐𝒏

𝑫𝒂𝒚𝒔 𝑷𝒆𝒓 𝒀𝒆𝒂𝒓 𝟏𝟎𝟎. 𝟎𝟎 𝒙 𝟎. 𝟒𝟎 𝒙 𝟏 ≈ 2.09 𝟑𝟔𝟓 Market expects underlying to be between up and down 2.09 with 68.2% certainty CBOE OPTIONS INSTITUTE

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Put / Call Parity Introduction Three trading instruments – call, put, and stock A long or short position in one of these instruments may be replicated using two of the others For example – Long Call + Short Put = Long Stock

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Put / Call Parity Example Creating a synthetic long stock position using options

Buy 1 XYZ 50 Call at 2.00 Sell 1 XYZ 50 Put at 2.00 Net Cost = 0.00

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Put / Call Parity Example – Payoff Table Creating a synthetic long stock position using options Stock Price 40.00 45.00 50.00 55.00 60.00

Long 50 Call 0.00 0.00 0.00 5.00 10.00

Short 50 Put (10.00) (5.00) 0.00 0.00 0.00

P/L (10.00) (5.00) 0.00 5.00 10.00

Profit / Loss is the same as Long 100 Shares at 50.00

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Put / Call Parity Example Creating a synthetic long stock position using options XYZ at 51.00 Buy 1 XYZ 50 Call at 2.00 Sell 1 XYZ 50 Put at 2.00 Net Cost = 0.00

Option Trades are just like long 100 XYZ at 50.00 Sell Short 100 XYZ at 51.00

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Put / Call Parity Example – Payoff Table Creating a synthetic long stock position using options Stock Price 40.00 45.00 50.00 55.00 60.00

Stock P/L Long 50 Call Short 50 Put 11.00 (10.00) 0.00 6.00 (5.00) 0.00 1.00 0.00 0.00 (4.00) 0.00 5.00 (9.00) 0.00 10.00

P/L 1.00 1.00 1.00 1.00 1.00

P/L is +1.00 at any price level at expiration

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Put / Call Parity Relationships

Long Stock = Long Call + Short Put Short Stock = Short Call + Long Put

Long Call = Long Stock + Long Put Short Call = Short Stock + Short Put Long Put = Short Stock + Long Call Short Put = Long Stock + Short Call

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CBOE Volatility Index Overview The CBOE Volatility Index or VIX is a consistent 30 day measure of implied volatility as indicated by S&P 500 Index option prices The VIX Methodology is considered the industry standard for a consistent measure of implied volatility Historically VIX has displayed an inverse relationship with the S&P 500 which resulted in it being referred to as “the fear index”

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CBOE Volatility Index 2H2015 - 1H2016 Price Action VIX vs. S&P 500® 2150

80

70

2050

60

1950

S&P 500

50

1850 40 1750 30

VIX

1650

1550 Jul-15

20

10 Aug-15

Sep-15

Oct-15

Nov-15

Dec-15

Jan-16

Feb-16

Mar-16

Apr-16

May-16

Jun-16

Data Sources: CBOE & Bloomberg CBOE OPTIONS INSTITUTE

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CBOE Volatility Index Inverse Relationship Why?

“Because they are panicking” - Billy Ray Valentine CBOE OPTIONS INSTITUTE

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CBOE Volatility Index Inverse Relationship S&P 500 Put Call Ratio 4.00

3.50

SPX Put Volume > Call Volume

3.00

2.50

2.00

1.50

1.00

SPX Put Volume < Call Volume

0.50

0.00 Jul-15

Aug-15

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Sep-15

Oct-15

Nov-15

Dec-15

Jan-16

Feb-16

Mar-16

Apr-16

May-16

Jun-16

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Interpreting VIX VIX as a Market Indicator VIX may be thought of as a sentiment indicator that shows excessive market complacency or fear Some market participants like to use VIX as a confirmation or new S&P 500 lows If VIX is not making a new high as the S&P 500 makes a new low the result may be a short term stock market bottom

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Interpreting VIX VIX as a Market Indicator VIX vs. S&P 500® 2150

80 VIX as a Market Indicator

70

S&P 500

2050

60

1950 50 1850

New SPX Low

40

VIX 1750

VIX ‘Not Confirming’ Low

30

1650

1550 Jul-15

20

10 Aug-15

Sep-15

Oct-15

Nov-15

Dec-15

Jan-16

Feb-16

Mar-16

Apr-16

May-16

Jun-16

Data Sources: CBOE & Bloomberg CBOE OPTIONS INSTITUTE

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Interpreting VIX VIX Futures Pricing Unlike many financial futures markets there is not a ‘fair value’ relationship between VIX and the associated futures contracts At times VIX futures are priced at a premium to spot VIX and at times VIX futures will be priced at a discount The pricing relationship is often referred to as being in contango or backwardation

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Interpreting VIX Volatility as a Tradable Asset VIX and Related Futures Pricing (Brexit) 26

24

Friday 6:30 am Chicago Time

22

20

Thursday Close

18

16

VIX

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Jul-16

Aug-16

Sep-16

Oct-16

Nov-16

Dec-16

Jan-17

Feb-17

Mar-17

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Interpreting VIX Standard Futures Daily Price Chart VIX vs. December 2015 Futures 28

December Front Month 24

December VIX 20

16

12 9/16

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Spot VIX

10/7

10/28

11/18

12/10

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Interpreting VIX Modified Futures Contract Standard VIX futures contracts expire each month As expiration approaches the spread between spot VIX and the futures contract narrows To compensate for this aspect of VIX futures price behavior a method was developed to compare with spot VIX The front two month futures are time weighted and the result is a modified VIX Futures Contract

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Interpreting VIX VIX as a Market Indicator Modified VIX Future 50

2200

45

S&P 500

40

2000

35

30

1800

25

Mod VIX Futures

20

1600

15

10 Jan-16

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VIX 1400 Feb-16

Mar-16

Apr-16

May-16

Jun-16

Jul-16

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Implied Volatility and VIX Outline Historical volatility tells us where we’ve been implied volatility is the market’s forecast of where we are going Put / Call Parity keeps option market pricing in line with the underlying and option options on the same stock Implied volatility is an annualized number which may be used to project the market’s expectation of price changes over any time period The CBOE Volatility Index (VIX) is a consistent measure of implied volatility focusing on a 30 day time period VIX and the relationship between the index and futures pricing is a potentially useful market indicator

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Summary Resources / Contact

Resources www.cboe.com/vix www.cfe.cboe.com Contact Info Russell Rhoads, CFA [email protected] (Shameless plug – I’m available for chapter presentations)

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