Options Lecture Texas A

1
Options Lecture Texas AM November 1, 2002

• Scott Mastro
• Structured Products Options Trader
• British Petroleum (BP) Energy Company

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Plain Vanilla Options

• Call Option gives the right but not an obligation
  to buy the underlying at the specified price.
• Put Option gives the right but not the obligation
  to sell the underlying at a specified price.

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Complex Options

• Straddle
• Strangle
• Butterfly
• Condor
• Call Spread
• Put Spread
• Time Spread

• Ratio Spread

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Natural Gas Options

• Monthly options are either Exchange (American) or
  over-the-counter (European).
• Gas Daily Options are settled on a daily basis.
• There are also different pipe options available
  at the different spot price indexes.

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Option Benefits

• Reduce risk
• Reduce cost
• Increase profitability
• Protect position
• Lock in profits

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Volatility

• Mean-reverting tendencies
• Most markets have a typical long-term average
  volatility or mean volatility.
• Short term volatility tends to gyrate back and
  forth through this mean.
• This tendency is also evident in what is known as
  the volatility cone.

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Volatility Cone
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Volatility Cone (cont.)

• The cone shows the stability of the volatility on
  the long term and instability in the short term.
• Very similar to flipping a coin
• (For example) If I flip a coin 1,000 times and
  assign a 1 to heads and a 1 to tails. The
  results will be fairly close to 50/50. If I flip
  a coin 20 times then I can have streaks of heads
  or tails only.

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Volatility (cont.)

• Volatility exhibits trending behavior.
• It can be persistent over short periods of time
  thus the runs in flipping a coin and getting a
  heads or tails in streaks.
• These characteristics are very important for
  traders that consider themselves volatility (vol)
  traders.
• Why is it important to know this?

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Natural Gas Volatility

• Implied volatility almost always trades above the
  historical volatility.
• Winter (Nov-Mar) implied volatility is usually
  higher than summer (Apr-Oct) volatility.
• Implied volatility (IV) is affected by unexpected
  changes in weather forecasts.
• IV is affected by the market participants view on
  future supply of gas.
• IV creeps higher as longer-dated options become
  shorter dated options.

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Skewness Kurtosis

• A perfectly normal distribution can be fully
  described by its mean and standard deviation.
• Skewness and Kurtosis as used to describe the
  extent of the difference between actual frequency
  distribution and a true normal distribution.

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Skewness Kurtosis (cont.)

• Skewness can be thought of as a the lopsidedness
  of the distribution curve.
• It basically is saying that on tail of the
  distribution curve is longer than the the other
  tail and not exactly alike.
• Positive Skew () Longer right-handed skew
• Negative Skew (-) Longer left-handed skew

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Skewness Graph
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Kurtosis

• Kurtosis of a distribution is the extent to which
  the peak of the distribution is unusual tall and
  pointed or low and flat.
• Positive () Kurtosis peak of distribution has
  a tall pointed peak with flat tails, leptokurtic.
• Negative (-) Kurtosis low flat peak and thin
  tails, platykurtic.
• Neutral Kurtosis perfectly normal distribution,
  mesokurtic.

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Kurtosis Graph
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Kurtosis (cont.)

• Almost all markets exhibit positive kurtosis.
• More days with smaller moves than normal.
• More days with bigger moves than normal.
• Fewer days with intermediate moves.

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Arbitrage Trading

• Using a modified Black Scholes Model, option
  arbitrage traders look for the opportunity to buy
  options that are below theoretical value and sell
  options that are above theoretical value.
• The key to success in trading for theoretical
  value is the trader must manage his or her risk
  with respect to the Greeks delta, gamma, theta,
  and vega.

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Arbitrage Trading Examples

• Sell 100 Dec 3.70 3.90 Put Spread _at_ .09 Sell 14
  Dec futures _at_ 4.00
• Buy 100 Dec 3.9 4.2 Fence _at_ . 02 Buy 79 Dec
  futures _at_ 4.00
• Buy 100 Dec 4.2 3.70 Fence _at_ .055 Sell 65 Dec
  futures _at_ 4.00
• Execution of futures or swaps is very critical in
  capturing the theoretical edge.
• Why?

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Hedging with Options in NG

• Consumers (Utilities, corporations, etc.) are
  naturally short hedgers.
• Producers (Energy companies) are naturally long
  gas due to their exploration and production
  activities.

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Protective Calls and Puts

• Purchasing calls or puts for price protection is
  analogous to buying an insurance policy.
• The price of an option is the insurance policy
  premium.
• The difference between he exercise price and the
  current price of the underlying is analogous to
  the deductible.
• The hedger maintains the open-ended profit
  potential or unlimited upside.

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Protective Call Puts (cont.)

• A consumer who has purchased a call option is
  long the synthetic put.
• A producer who has purchased a put option is long
  the synthetic call.

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Covered Writing

• Selling calls or puts offers limited protection
  against adverse moves.
• Allows the writer to earn income against his
  current position.
• A consumer who has sold put options is short a
  synthetic call.
• A producer who has sold call options is short a
  synthetic put.

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Fences (Collars)

• Simultaneously purchasing a protective option and
  selling a covered option.
• Long Fence long underlying short call long
  put.
• A long fence is equivalent to a synthetic bull
  vertical spread.
• Short Fence short underlying long call
  short put.
• A short fence is equivalent to a synthetic bear
  vertical spread.

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Fences (cont.)

• Fences offer protection at little or no cost, and
  sometimes a credit.
• They also allow a hedger to participate in
  favorable market movement.

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Case Studies