# Equity Options

Can investors/speculators use equity options to boost return through buying and selling leverage (calls), and/or buying and selling insurance (puts)? If so, which strategies work best? These blog entries relate to trading equity options.

**February 6, 2012** - Equity Options, Volatility Effects

Can investors usefully predict the short-term direction of the stock market by contrasting the outlooks implied by out-of-the-money (OTM) and at-the-money (ATM) market index options. In the October 2011 update of their paper entitled “Implied Volatility Spreads and Expected Market Returns”, Turan Bali, Ozgur Demirtas and Yigit Atilgan investigate the relationship between stock market index implied volatility spread (slope of the volatility smile) and future stock market return. They consider several measures of the implied volatility spread, such as the difference in implied volatilities between the S&P 500 Index OTM put option and the ATM call option that have the highest open interest or trading volume each day. They define moneyness as the ratio of strike price to stock price, with ATM (OTM) having moneyness between 0.95 and 1.05 (from 0.8 to 0.95). They exclude options with time to expiration less than 10 days or more than 60 days, options priced less than $0.125 and options with missing or anomalous data. Using daily closing prices for S&P 500 Index options and S&P 500 Index daily opening and closing levels from January 4, 1996 through September 10, 2008, along with contemporaneous firm and economic data used in robustness tests, *they find that:* Keep Reading

**January 9, 2012** - Equity Options, Fundamental Valuation, Volatility Effects

Are realized (actual historical) and implied volatilities the whole story for equity option valuation? In their December 2011 paper entitled “Fundamental Analysis and Option Returns”, Theodore Goodman, Monica Neamtiu and Frank Zhang investigate the extent to which the equity options market fails to recognize volatility of firm operations (accounting data) and whether any such failure is exploitable. They focus tests on long, one-month-to-expiration, at-the-money straddles (long both a call and a put), which profit from large moves in underlying stock prices. They estimate future volatility in firm fundamentals via regression based on a combination of short-term sales/earnings growth and long-term sales/earnings growth volatility (standard deviation over the last six years). They isolate a “pure” expected fundamental volatility via regression versus implied volatility and the implied-realized volatility gap. Using data as available to estimate the relationship between fundamental volatility and returns on options for individual U.S. stocks during January 1996 through September 2010 (52,251 firm-quarters involving 3,481 distinct firms), *they find that:* Keep Reading

**October 26, 2011** - Equity Options, Volatility Effects

An upward (downward) trend in implied volatilities with option maturity indicates that investors expect volatility to increase (decrease) over time. Do such expectations reliably predict future stock options prices? In his October 2011 paper entitled “Volatility Term Structure and the Cross-Section of Option Returns”, Aurelio Vasquez investigates whether the implied volatility term structure (measured as slope of implied volatilities across at-the-money options with receding expiration dates) predicts future option returns. Specifically, each month he ranks stocks into deciles by volatility term structure slope and then calculates future returns for extreme deciles from five option trading strategies: (1) naked calls; (2)naked puts; (3) straddles; (4) delta-hedged calls; and, (5) delta-hedged puts. He calculates returns relative to the initial prices of the options traded. Using monthly closing bid and ask prices for at-the-money options (moneyness between 0.95 and 1.05) on a broad sample of U.S. stocks, and associated firm characteristics, during January 1996 through June 2007 (260 stocks per month on average), *he finds that:* Keep Reading

**September 26, 2011** - Equity Options

Does a simple strategy of iteratively selling covered calls (buy-write) on the Russell 2000 Index beat buying and holding the index? In their September 2011 paper entitled “15 Years of the Russell 2000 Buy‐Write”, Nikunj Kapadia and Edward Szado evaluate returns on ten alternative buy‐write strategies for the Russell 2000 Index. Specifically, they consider one-month and two-month maturities and five levels of approximate moneyness: at-the-money (ATM); 2% and 5% in-the-money (ITM); and, 2% and 5% out-of-the-money (OTM). They estimate spread trading friction based on selling at the bid or at the bid-ask midpoint. They hold to expiration and cash settle at approximate expiration intrinsic value. Using monthly Russell 2000 Index total returns and Russell 2000 Index option bid-ask and implied volatility data from January 1996 through March 2011 (182 months), *they find that:* Keep Reading

**September 13, 2011** - Equity Options

In his 2011 book entitled *The Market Taker’s Edge: Insider Strategies from the Options Trading Floor,* author Dan Passarelli “offers lessons from the trading pits from the perspective of a professional trader turned options evangelist for the benefit of both aspiring professional traders and nonprofessional traders alike.” According to the book’s foreword: “What the trading industry has needed is a book that brings professional-trading experience and real-world know-how to the self-directed, individual trader; that is what Dan Passarelli’s book delivers.” Some *notable points from the book are:* Keep Reading

**July 13, 2011** - Equity Options, Volatility Effects

Are there differences in implied volatilities (option pricing) between major indexes and the exchange-traded funds (ETF) that track them? In their 2011 paper entitled “The Implied Volatility of ETF and Index Options”, Stoyu Ivanov, Jeff Whitworth and Yi Zhang compare implied volatilities of SPDR Dow Jones Industrial Average (DIA), SPDR S&P 500 (SPY) and PowerShares QQQ (QQQ) to those of the Dow Jones Industrial Average (DJIA), the S&P 500 Index and the NASDAQ 100 Index, respectively. They note that ETF prices may deviate from underlying index levels because: (1) ETFs incorporate trading frictions from rebalancing and management fees; (2) ETF composition may differ slightly from that of the underlying index due to trading cost constraints; (3) ETFs accumulate dividends in a non-interest bearing account for periodic lump sum distribution; and, (4) ETFs trade until 4:15 p.m., while indexes close at 4:00 p.m. Also, index options are European, while ETF options are American. Using index levels at the close and ETF prices within one second of 4:00 p.m. during 3/10/99 through 12/29/06, and associated ETF and index near-to-expiration options price data filtered for reliability during 2003 through 2006, *they find that:* Keep Reading

**July 6, 2011** - Equity Options, Individual Gurus

A reader suggested Condor Options as a guru for review. To conduct a review, we evaluate the Condor Options Newsletter Performance table of iron condor trades (with a few hedging trades) available via the Condor Options Performance self-assessment. This table includes entry and exit dates, trade duration, specific positions/strike prices, initial value (credit), total amount risked (Real Risk), final value (credit), final value as a percentage of amount risked (% Return), risk-adjusted trade size, return on investment (Trade ROI) and cumulative value of a $1,000 initial investment (VAMI). The initial and final trade values account for bid-ask spread by sampling actual fill quotes, but they do not account for broker trading commissions. This evaluation accepts the basic premises of performance assessment as presented in the table. Using the Condor Options Newsletter Performance table as of the end of June 2011, covering closed trades from initial position entry on 5/11/07 through 6/10/11 (162 trades), *we find that:* Keep Reading

**May 2, 2011** - Equity Options

Does the market compensate buyers of illiquid options? In their March 2011 paper entitled “Illiquidity Premia in the Equity Options Market”, Peter Christoffersen, Ruslan Goyenko, Kris Jacobs and Mehdi Karoui investigate the impact of illiquidity of equity options and underlying stocks on option returns. They consider two option expiration horizons, short-term (20 to 70 days) and long-term (71 to 180 days), segmented by moneyness as in-the-money (ITM), at-the-money (ATM) and out-of-the-money (OTM). They compute option returns using end-of-day quoted bid-ask midpoints. They define stock illiquidity as the effective spread obtained from high-frequency intraday trade-and-quote data and option illiquidity with quoted end-of-day bid-ask spreads relative to midpoints. Using daily option closing bid and ask quotes for those S&P500 components that have traded options over the entire period of 1996 through 2007 (341 firms), filtered for reliability, along with comparable data for underlying stocks, *they find that:* Keep Reading

**April 14, 2011** - Equity Options

Can investors exploit greed among naive traders by selling them the most lottery-like equity options? In the March 2011 version of their paper entitled “Stock Options as Lotteries”, Brian Boyer and Keith Vorkink investigate the relationship between skewness of expected returns (a measure of prospects for extreme payouts, a proxy for “lotteryness”) and actual future returns for options on individual stocks. On the first trading day and the second Friday of each month, they create 40 option portfolios sorted first into eight expiration horizons and then into expected skewness quintiles. Based on end-of-day bid-ask midpoints, they calculate the return for each option assuming it is held to expiration (ignoring the possibility of early exercise) and returns for the 40 portfolios as the equally weighted average of constituent option returns. Using end-of-day bid and ask quotes, open interest and trading volume for options (screened for liquidity and obvious errors) and prices for the underlying U.S. common stocks during approximately 1996 through 2009, *they find that:* Keep Reading

**April 12, 2011** - Equity Options, Volatility Effects

Are options for volatile stocks overpriced? In the September 2010 version of their paper entitled “Cross-Section of Option Returns and Stock Volatility”, Jie Cao and Bing Han investigate the relationship between option return and price volatility of the underlying stock. The focus on delta-hedged positions in options and underlying stocks calibrated such that the combination is insensitive to stock price changes. For most analyses, they use the closing bid-ask midpoint as the option price. Using price and trading data for approximately at-the-money individual stock options about 1.5 months from expiration (filtered for reliability) on approximately 6,000 underlying U.S. stocks over the period January 1996 through October 2009 (about 200,000 observations each for puts and calls), *they find that:* Keep Reading