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Single Stock Option’s Seminar

Learn about option trading strategies, volatility concepts, and risk management in this comprehensive seminar. Gain insights from experts in the field from Morgan Stanley and Deutsche Bank.

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Single Stock Option’s Seminar

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  1. Single Stock Option’s Seminar Part I Option Trading Overview By Steve D. Chang Morgan Stanley Dean Witter Part II Volatility Trading Concept and Application By Charles Chiang Deutsche Bank A.G.

  2. Volatility Trading Concept and Application By Charles Chiang Vice President, GED Trading, Deutsche Bank

  3. Index • Option Trading Strategies • What Is Volatility? • Volatility and Option Pricing • Delta-Neutral Strategy • Case Study 1 • Case Study 2 • Risks in Volatility Trading • Application of Option Volatility Trading • Option Risk Management • Equity Derivative Structured Product • Summary and Appendix (introduction on Deutsche Bank A.G.)

  4. Option Trading Strategy • Leverage Trading / Directional Trading Strategy • buy call, sell put, call spread, etc • buy put, sell call, put spread, etc Take a view on the market direction • Volatility Trading Strategy Take a view on the market volatility

  5. What Is Volatility? • A measure of the degree of the fluctuations • For example, compare the two listed companies in Taiwan • TSMC (ticker: 2330) • Chung Hwa (ticker: 2412) Intuitively, which one do you think is more volatile? ?

  6. What Is Volatility? Volatility in statistical language • Annual volatility • Daily volatility 2330 2412

  7. Volatility and Option Pricing • Option price is influenced by • Underlying Stock Price • Strike price • Maturity • Interest rate • Dividend • Volatility • Assume that all the other factors are equal, will you pay the same price for the option written on TSMC and Chung Hwa?

  8. Actual Volatility Option Pricing Model Fair Value of Option Implied Volatility Option Pricing Model Market Value of Option Volatility and Option Pricing • The price of a call option increases when the underlying stock becomes more volatile. • From buyers’ point of view, higher volatility means More chances to expire in the money; • From issuers’ point of view , higher volatility means Higher hedging cost • Two types of volatility • implied volatility • actual volatility

  9. Delta-Neutral Strategy • Delta • Delta-neutral is the position where • In a Delta-neutral position, small changes in stock price will not change the value of the stock-option portfolio. • An example

  10. Case Study 1 • Buy 1,000 call option on TSMC. Assume that • European style, expire in two months; • Sold at the money; • One option exchanged for one share; • Interest rate r=2%p.a.; • No dividend will be paid; • actual annual volatility σY= 38%. • Sell underlying stock to keep the portfolio Delta-neutralby rehedging it from time to time.

  11. Case Study 1 • The benchmark for rehedging decision is σD= 2.4%, which means Daily change of stock price < 2.4% Enjoy a leisure day Daily change of stock price  2.4% Adjust the stock position to achieve Delta-neutral • In our example, altogether there are 10 rehedges during the two- months’ life of the call option

  12. Case Study 1 • When an investor buy an option whose implied volatility is lower than its actual one, he makes money no matter to which direction the market moves ! • When σY=38%, 48% and 28%, the outcomes of this strategy are: Fair Price

  13. Case Study 2 • Now consider buying 1,000 options on Chunghwa and short sell the underlying stock to hedge. Assume that all factors are the same as in the example of TSMC, except that actual annualised volatility is 25%. • when σY=25%, 35% and 15%, the results are as followed: Fair Price

  14. Case Study 2 • Please note that the price for options written on Chung Hwa is relatively cheaper than that on TSMC (i.e. the former has a lower percentage price). • This is because the volatility of TSMC’s stock is higher than that of Chung Hwa’s. Fair Price Fair Price

  15. Risks in Volatility Trading • Volatility trading strategy may be subjected to potential loss if the writer/buyer of option estimates the market volatility incorrectly. • A single shock to stock price (e.g. 911 event, corporate action etc, whether positive or negative, may lead to great increase/decrease of the actual volatility of the underlying stock • The daily up and down limit on underlying stock may obstruct timely rehedging and other friction in the underlying market (transaction cost, bid/offer spread, liquidity) • Option model assumptions • Regulatory risks such as foreign ownership limit, short selling restriction

  16. Application of Option Volatility Trading (1) Option Risk Management • Market makers usually reduce optionality risks by buying/selling options of same/different strike, maturity and hedge the net delta position between different options. For example • Option portfolio may consist of three parts: • Short call with higher implied volatility(CH) • Long call with lower implied volatility(CL) • Long underlying stock • The premium of CL eats up part of their profit • When market volatility moves up unexpectedly, the profit in CL partially offset the loss in CH

  17. Application of Option Volatility Trading • Covered warrant risk management - buy short term single stock options to cover gamma risks in the the warrant book • Index option volatility vs. single stock volatility - hedging or arbitrage between single stock volatility and index volatility • CB volatility vs. single stock option volatility - take advantage on volatility differential between implied volatility from CB and single stock options (1) Option Risk Management — Examples

  18. Equity Linked Note Equity Derivatives Bond = + Return: Coupon/Redemption (fixed or dependent on underlying performance) Structure: Bull/Bear/Range Underlying: Stock/Basket/Index Application of Option Volatility Trading • One common example of equity derivative structured product is Equity Linked Note (ELN). • Most popular examples are: • Principal Guaranteed Notes • High Yield Notes (HYN) (2) Equity Derivative Structured Products

  19. Equity Derivative Structured Products Principle Guaranteed Notes • Considerations: U/L, participation, protected portion • Structure: Investor + note + options • Pricing: participation = • (unprotected portion + interest) / option value • Types: range / bull / bear

  20. Equity Derivative Structured Products Principle Guaranteed Notes — Example 1 U/Ls: TSMC • Tenor: 1/2 year on notes • Options: + 100~110 call spread • Notes: + zero coupon note • Protection: 97% • Issue price: 100% • Participation: 100% of the appreciation of U/L on maturity • Redemption: on maturity, if • * appreciation of U/L < 100%, redemption will be 97% • * 100% <= appreciation of U/L < 110%, redemption will be • 97% + appreciation of U/L • * appreciation of U/L >= 110%, redemption will be • 97% + 10%

  21. Equity Derivative Structured Products • Principle Guaranteed Notes — Example 2 • U/Ls: TSMC • Tenor: 1/2 year on notes • Options: + 100~110 call spread • Notes: + zero coupon note • Protection: 94% • Issue price: 100% • Participation: 100% of the appreciation of U/L on maturity • Redemption: on maturity, if • * appreciation of U/L < 100%, redemption will be 94% • * 100% <= appreciation of U/L < 110%, redemption will be • 94% + appreciation of U/L • * appreciation of U/L >= 110%, redemption will be 94% + 10% • The difference in protection rate above indicates a different implied volatility in the embedded call options

  22. Equity Derivative Structured Products High Yield Notes • Considerations: U/L, issue price, annual yield • Structure: Investor + note - options • Pricing: issue price = PV(par) - option value • Types: bull / bear / range

  23. Equity Derivative Structured Products High Yield Notes — Example • U/Ls: TSMC at $78.64 • Tenor: 60 days on notes • Options: - 90% put, strike at $ 70.78 • Notes: + zero coupon note • Issue price: 98% of par • Ann. Yield: 12.2% • Redemption: on maturity, if • * U/L close >= 90%, redemption will be at 100% of par • * U/L close < 90%, redemption will be the stock price on • maturity / $70.78

  24. Summary • Volatility trading concept and application • Making profit without taking directional view but view on market volatility through delta-neutral strategy. (Provided that short selling facility on the underlying is possible) • Hedging option portfolio • volatility risk (Gamma and Vega risk) • liquidity risk (the discontinuous movement of stock price) • Equity derivatives structured product • combining equity options and fixed income securities whose feature depends on options premium paid/ sold

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