Capturing the Volatility Premium Through Call Overwriting
White Paper No. 34
Ennis Knupp - EVALUATING THE PERFORMANCE CHARACTERISTICS OF THE CBOE S&P 500 PUTWRITE INDEX
AN ANALYSIS OF INDEX OPTION WRITING
FOR LIQUID ENHANCED RISK-ADJUSTED RETURNS
Highlights from: "VIX Futures and Options – A Case Study of Portfolio Diversification
During the 2008 Financial Crisis"
Highlights from Case Study on BXM Buy-Write Options Strategy
An Historical Evaluation of the
CBOE S&P 500 BuyWrite Index Strategy
The Benefits of Call Overwriting
Finding Alpha Via Covered Index Writing
Glossary of Terms:
An option that can be exercised anytime during its life. The majority of exchange-traded options are American.
An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult to predict. This term was popularized by Nassim Nicholas Taleb, a finance professor and former Wall Street trader.
A ratio used to determine return relative to drawdown (downside) risk in a hedge fund. Calculated as:
Calmar Ratio = (Compounded Annual Return/Maximum Drawdown)
Founded in 1973, the CBOE is an exchange that focuses on options contracts for individual equities, indexes and interest rates. The CBOE is the world's largest options market. It captures a majority of the options traded. It is also a market leader in developing new financial products and technological innovation, particularly with electronic trading.
A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.
An option that can only be exercised at the end of its life, at its maturity. European options tend to sometimes trade at a discount to its comparable American option. This is because American options allow investors more opportunities to exercise the contract.
The futures market is a centralized marketplace for buyers and sellers from around the world who meet and enter into futures contracts. Pricing can be based on an open cry system, or bids and offers can be matched electronically. The futures contract will state the price that will be paid and the date of delivery. But don't worry, as we mentioned earlier, almost all futures contracts end without the actual physical delivery of the commodity.
1. For a call option, when the option's strike price is below the market price of the underlying asset.
2. For a put option, when the strike price is above the market price of the underlying asset. Being in the money does not mean you will profit, it just means the option is worth exercising. This is because the option costs money to buy.
A mathematical formula relating to the long-term growth of capital developed by John Larry Kelly Jr. The formula was developed by Kelly while working at the AT&T Bell Laboratories. The formula is currently used by gamblers and investors to determine what percentage of their bankroll/capital should be used in each bet/trade to maximize long-term growth.
Kelly % = W-[(1-W)/R]
(W) the winning probability factor
(R) the win/loss ratio
1.The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.
2. The amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged.
Leverage is most commonly used in real estate transactions through the use of mortgages to purchase a home.
The stock exchange based in New York City, which is considered the largest equities-based exchange in the world based on total market capitalization of its listed securities. Formerly run as a private organization, the NYSE became a public entity in 2005 following the acquisition of electronic trading exchange Archipelago. The parent company of the New York Stock Exchange is now called NYSE Euronext, following a merger with the European exchange in 2007.
Also known as the "Big Board", the NYSE relied for many years on floor trading only, using the open outcry system. Today, more than half of all NYSE trades are conducted electronically, although floor traders are still used to set pricing and deal in high volume institutional trading.
1. The income received by an investor who sells or "writes" an option contract to another party.
2. The current price of any specific option contract that has yet to expire. For stock options, the premium is quoted as a dollar amount per share and most contracts represent the commitment of 100 shares.
The replacement of an option with a new option that has a lower strike price. The use of a roll down means that the investor does not have to exercise the option. Instead, the investor extends the time period over until the investment expires.
A term identifying the date on/by which the specified actions of a contract can be reasonably completed. This date is important, as it is generally considered legally binding.
Volatility changes can have a potential impact - good or bad - on any options trade you are preparing to implement. In addition to this so-called Vega risk/reward, this part of the options volatility tutorial will teach you about the relationship between historical volatility (also known as statistical, or SV) and implied volatility (IV), including how they are calculated, although most trading platforms provide this for you.
Perhaps the most practical aspect of a volatility perspective on options strategies and option prices is the opportunity it affords you to determine relative valuation of options. Due to the nature of markets, options may often price in events that are expected. Therefore, when looking at option prices and considering certain strategies, knowing whether options are "expensive" or "cheap" can provide very useful information about whether you should be selling options or buying them. Obviously, the old adage of buy low, sell high applies as much here as it does in the world of stocks and commodities.
1. For a call, when an option's strike price is higher than the market price of the underlying asset.
2. For a put, when the strike price is below the market price of the underlying asset
A special group of services that many brokerages give to special clients. The services provided under prime brokering are securities lending, leveraged trade executions, and cash management, among other things. Prime brokerage services are provided by most of the large brokers, such as Goldman Sachs, Paine Webber, and Morgan Stanley Dean Witter.Settle for Cash
A settlement method used in certain future and option contracts whereby, upon expiry or exercise, the seller of the financial instrument does not deliver the actual but transfers the associated cash position.
A ratio used mainly in the context of hedge funds. This risk-reward measure determines which hedge funds have the highest returns while enduring the least amount of volatility. The formula is as follows:
Sterling Ratio = (Compounded Annual Return/Average Maximum Drawdown-10%)
This formula uses the average for risk (drawdown) and return over the past three years. Drawdown is calculated at the maximum potential loss in the given year.
The month, day and year that an order is executed in the market. The trade date is when an order to purchase, sell or otherwise acquire a security is performed. The trade date can apply to the purchase, sale or transfer of bonds, equities, foreign exchange instruments, commodities, futures, etc. In some cases, the trade date will be recorded on the previous day, for trades that are executed very early, or on the next day, in the case of orders that are executed very late in the day.
The theory that when the Weighted Average Cost of Capital (WACC) is minimized, and the market value of assets are maximized, an optimal structure of capital exists. The Traditional Theory of Capital Structure says that a firm's value increases to a certain level of debt capital, after which it tends to remain constant and eventually begins to decrease.
The ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge".
There are three variations of volatility indexes: the VIX tracks the S&P 500, the VXN tracks the Nasdaq 100 and the VXD tracks the Dow Jones Industrial Average.