Austin CFA Society - Indexes

S&P 500 & VIX Index Options for Hedging and Speculating
Russell Rhoads, CFA Instructor The Options Institute
CHICAG BO O ARDO PTIONSEXCHANG E
Presentation Outline
S&P 500 Index Options

Index Option Overview Tax Advantages Protective Put Collar
VIX Index Futures and Options

VIX Overview VIX Futures / Options VIX SPX Relationship UMass Study
Index Option Overview

Options on:
DIA SPY QQQQ IWM
Are these Index Options?
No.they are ETF Options.

Index Options Cash Settlement $100 Multiplier European exercise AM or PM settlement Special tax treatment
ETF Options Share Delivery 100 Shares American exercise PM settlement
ETF Options are like stock options The underlying is 100 shares Exercise/Assignment: Buy/Sell Shares Index Options are different The underlying is a cash value Exercise/Assignment: Receive/Pay Cash
The dollar cost of an index option is:
$100 times the stated option price.
SPX 1275 Call @ 18.00
Price of Option = $100 x 18.00 = $1800
Tax Advantages
ETFs and ETF options are treated like stock and stock options*
Broad-Based Index Options receive 60-40 treatment*

* According to Taxes and Investing, published by The Options Industry Council, available from http://www.cboe.com/LearnCenter/RCGeneral.asp Note: IRS regulations may change. Seek professional tax advice.
Tax Advantages
Tax Treatment -
Section 1256 Contracts: regardless of holding period, profits and losses are treated as 60% long-term and 40% short-term.

Reported on Form 6781 and Schedule D
Positions are marked to market at year end and taxed as if closed. Year-end prices become basis for next year.
Protective Put
2/10/2011 S&P 500 Index @ 1325.00

Long S&P 500 Indexed Portfolio Concerned about a market correction (10%) between now and quarter end Consider buying put options for protection Quarter end index options available
Protective Put
Current S&P 500 Index @ 1325.00 Outlook S&P 500 Index @ 1192.50 (down 10%)
March (3/31) S&P 500 Option Prices Price

1200 Put 1225 Put 1250 Put 1275 Put 1300 Put 1325 Put 1350 Put 5.20 6.80 9.30 12.80 18.40 26.80 39.50
Protective Put
Before choosing an option check scenarios Market down 10% Market flat Market up 5%

Protective Put
Outcome #1 10% Drop SPX @ 1192.50

1200 Put 1225 1250 Put 1275 Put 1300 Put 1325 Put 1350 Put 5.20 Cost 6.80 9.30 12.80 18.40 26.80 39.50 2.30 Option 25.70 48.20 Profit/Loss 69.70 89.10 105.70 118.00 -132.50 S&P 500 -132.50 Profit/Loss -132.50 -132.50 -132.50 -132.50 -130.20 -106.80 -84.30 Point -62.80 Profit/Loss -43.40 -26.80 -14.50 -9.83% % Portfolio -8.06% -6.36% Profit/Loss -4.74% -3.28% -2.02% -1.09%
Protective Put
Outcome #2 Flat Market SPX @ 1325.00

1200 Put 1225 1250 Put 1275 Put 1300 Put 1325 Put 1350 Put 5.20 Cost 6.80 9.30 12.80 18.40 26.80 39.50 -5.20 Option -6.80 -9.30 Profit/Loss -12.80 -18.40 -26.80 -14.50 0.00 S&P 500 0.00 Profit/Loss 0.00 0.00 0.00 0.00 -5.20 -6.80 -9.30 Point -12.80 Profit/Loss -18.40 -26.80 -14.50 -0.39% % Portfolio -0.51% -0.70% Profit/Loss -0.97% -1.39% -2.02% -1.09%
Protective Put
Outcome #3 5% Gain SPX @ 1391.25

1200 Put 1225 1250 Put 1275 Put 1300 Put 1325 Put 1350 Put 5.20 Cost 6.80 9.30 12.80 18.40 26.80 39.50 -5.20 Contract -6.80 -9.30 Profit/Loss -12.80 -18.40 -26.80 -39.50 66.25 S&P 500 66.25 Profit/Loss 66.25 66.25 66.25 66.25 61.05 59.45 56.95 Point 53.45 Profit/Loss 47.85 39.45 26.75 4.61% % Portfolio 4.49% 4.30% Profit/Loss 4.03% 3.61% 2.98% 2.02%
Protective Put
60
40
20
S&P 500
1200 1225 1250 1275 1300 1325 1350 1375
-20
-40
1350 Put
-60
1325 Put 1300 Put
Collar
Collar Less expensive hedging alternative than purchasing a put Involves protective put combined with short (covered) call Income from selling call offsets cost of put Trade off is potentially less upside

Collar
Collar #1 1300 Call 1325 Call 1350 Call Price 44.30 25.10 14.10 1300 Put 1325 Put 1350 Put Price 18.40 26.80 39.50
Buy 1 1300 Put @ 18.40 Sell 1 1350 Call @ 14.10 Net Debit = 4.30
Collar
Buy 1 1325 Put @ 26.80 Sell 1 1350 Call @ 14.10 Net Debit = 12.70
Collar
Buy 1 1300 Put @ 18.40 Sell 1 1325 Call @ 25.10 Net Credit = 6.70
Collar
SPX Down 10% Flat Up 5% Long 1300 Put 107.50 0.00 0.00 Short 1350 Call 0.00 0.00 -41.25 Collar Cost -4.30 -4.30 -4.30 SPX Profit/Loss -132.50 0.00 66.25 Total Profit/Loss -29.30 -4.30 20.70 % Profit/Loss -2.21% -0.32% +1.56%
#1
#2
SPX Down 10% Up Flat5%
Long 1325 Put 132.50 0.00
Short 1350 Call 0.00 -41.25 0.00
Collar Cost -12.70 -12.70
SPX Profit/Loss -132.50 66.25 0.00
Total Profit/Loss -12.70 13.30 -12.70
% Profit/Loss -0.96% +1.00% -0.96%
SPX Down 10% Flat Up 5%
Long 1300 Put 107.50 0.00 0.00
Short 1325 Call 0.00 0.00 -66.25
Collar Credit +6.70 +6.70 +6.70
SPX Profit/Loss -132.50 0.00 66.25
Total Profit/Loss -18.30 6.70 6.70
% Profit/Loss -1.38% +0.51% +0.51%
#3
Collar
30
20
S&P 500
10
0 -10
1325 Put / 1350 Call 1300 Put / 1325 Call 1300 Put / 1350 Call
1200
1225
1250
1275
1300
1325
1350
1375
-20
-30
-40
S&P 500 Summary

Protective put Long portfolio combined with long put option Offers protection against move lower Collar Combines protective put with short call Result is cheaper protection Some upside performance may be sacrificed
VIX Index
The VIX CBOE Volatility Index Measures S&P 500 implied volatility. Based on S&P 500 Option bid/ask quotes. Uses the nearby options with at least 8 days until expiration. Has been promoted as a fear index by the business media.
VIX Futures / Options

VIX Futures Introduced in 2004 Value is $1000 x the level of the VIX Index. Trade the next 8 months of expiration. Expire on Wednesday 30 days before corresponding S&P 500 option expiration. Have very unique characteristics relative to other financial futures.

Pricing VIX Future Feb VIX VXG1 @ 21.65 = $21,650 Minimum price move = .05 or $50. +/- 1.00 price change = +/- $1000.

Futures Pricing Pricing is anticipatory, no cost of carry. Future price reflects market opinion of the future direction of the spot VIX Index. At times the VIX future price is higher than the index and at times it is lower.

November 09 VIX Futures vs. VIX Spot Index
32
VIX Index
30
28
VXX09 Future
26
24
22
20 9/28/09
10/7/09
10/16/09
10/25/09
11/3/09
11/12/09

Futures Open Interest Growth 175,000 150,000 125,000 100,000 75,000 50,000 25,000 0 Feb-06 Jul-06 Dec-06 May-07 Oct-07 Mar-08 Aug-08 Jan-09 Jun-09 Nov-09 Apr-10 Sep-10

VIX Options Introduced in 2006 Have gained wide acceptance among individual and institutional traders Becoming favored hedging vehicle for some institutions Index options, but closely related to VIX Futures


Unusual Pricing
It is not uncommon for VIX options to appear to be cheap or expensive when using the VIX Index as the underlying.

The proper underlying pricing instrument should be the corresponding VIX future price.

Options - Unusual Pricing VIX Index @ 22.00 VIX November 20.00 Call @ 1.25 22.00 20.00 = 2.00 VIX November Future @ 20.50

Options - Unusual Pricing VIX Index @ 22.50 VIX December 25.00 Put @ 1.50 25.00 22.50 = 2.50 VIX December Future @ 24.00

Options Open Interest Growth
5,000,000 4,000,000
3,000,000
2,000,000
1,000,000
0
Feb-06 Jul-06 De c-06 M ay-07 Oct-07 M ar-08 Aug-08 Jan-09 Jun-09 Nov-09 Apr-10 Sep-10
Source www.cboe.com

VIX Futures / Options for Hedging There is an inverse relationship between the VIX and S&P 500 Index VIX Calls are used to hedge against weakness in stock prices Long VIX Futures positions may also be used to hedging purposes
VIX SPX Relationship

10 Worst S&P 500 Days Since 2007
Date 10/15/2008 12/1/2008 9/29/2008 10/9/2008 11/20/2008 11/19/2008 10/22/2008 10/7/2008 1/20/2009 11/5/2008 11/12/2008 SPX Change -9.03% -8.93% -8.81% -7.62% -6.71% -6.12% -6.10% -5.74% -5.28% -5.27% -5.19% VIX Front Month Future Change 18.61% 13.61% 14.14% 14.79% 5.29% 9.79% 10.34% 11.93% 10.09% 8.12% 9.13%

May 6, 2010 5 Minute Chart
1180 42.50
1160
38.50
1140 S&P 500 VIX Index 1120
34.50
30.50
1100
26.50
1080 8:30
22.50 9:30 10:30 11:30 12:30 13:30 14:30
Data Source Bloomberg

1180 42.50
1160
38.50
1140 S&P 500 May VIX Future 1120
34.50
30.50
1100
26.50
1080 8:30
22.50 9:30 10:30 11:30 12:30 13:30 14:30

42.5
38.5 VIX Index May VIX Future 34.5
30.5
26.5
22.5 8:30
9:30
10:30
11:30
12:30
13:30
14:30
March 2010 VIX Call Options

VIX @ 15.95 / March VIX @ 17.80
ITM
Strike 10.00 13.00 14.00 15.00 16.00 17.00 18.00 19.00 20.00 21.00 22.50 24.00 25.00 27.50 30.00 Open Interest 185 73 220 3,587 15,232 27,109 18,177 24,696 51,549 42,200 99,924 37,284 175,211 155,210 203,623 Strike 32.50 35.00 37.50 40.00 42.50 45.00 47.50 50.00 55.00 60.00 65.00 70.00 75.00 80.00 Open Interest 135,923 161,540 23,138 60,017 11,530 13,485 3,841 27,191 4,513 35,274 31,254 520 101 1,102
OTM
ATM
OTM
OTM
UMass Study
Study Analyzed market activity from Aug 2008 Dec 2008 Added VIX option / futures positions to model portfolios Results demonstrated use of VIX as a hedging vehicle in times of extreme market turbulence
UMass Study
Model Portfolios Equity - 100% Stocks Balanced - 60% Stocks / 40% Bonds Diversified - 60.5% Stocks / 30.5% Bonds / 1.3% High Yield Bonds / 1.2% Hedge Funds / 0.1% Managed Futures / 0.3% Commodity / 1.6% Private Equity / 4.5% Real Estate
UMass Study
VIX Exposure 2.5% or 10% Front Month VIX Futures 1% or 3% One Month VIX ATM Calls 1% or 3% One Moth VIX OTM Calls

UMass Study
Result Highlights (Aug 2008 Dec 2008) Diversified (19.68%) + 1% ATM Calls (6.72%) + 3% ATM VIX Calls 20.78 + 1% OTM VIX Calls 17.70% + 3% OTM VIX Calls 97.18%

UMass Study
Conclusions Diversification benefits may not be realized at times Benefit of VIX exposure during times of high volatility was demonstrated Over long term VIX diversification may result in underperformance

VIX Summary
VIX Options and Futures have emerged as liquid and viable asset classes There is an inverse relationship between the VIX and the direction of stock prices VIX derivatives may be a viable alternative to other diversification techniques
Contact

Russell Rhoads, CFA
rhoads@cboe.com cboerhoads@gmail.com


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S&P 500 & VIX Index Options for Hedging and Speculating

Russell Rhoads, CFA Instructor The Options Institute

CHICAG BO O ARDO PTIONSEXCHANG E

S&P 500 Index Options

VIX Index Futures and Options

CHICAG BO O ARDO PTIONSEXCHANG E

Index Option Overview

DIA SPY QQQQ IWM

Are these Index Options?

No.they are ETF Options.

CHICAG BO O ARDO PTIONSEXCHANG E

Index Option Overview

ETF Options Share Delivery 100 Shares American exercise PM settlement

CHICAG BO O ARDO PTIONSEXCHANG E

Index Option Overview

CHICAG BO O ARDO PTIONSEXCHANG E

Index Option Overview

The dollar cost of an index option is:

$100 times the stated option price.

SPX 1275 Call @ 18.00

Price of Option = $100 x 18.00 = $1800

CHICAG BO O ARDO PTIONSEXCHANG E

Broad-Based Index Options receive 60-40 treatment*

CHICAG BO O ARDO PTIONSEXCHANG E

Reported on Form 6781 and Schedule D

CHICAG BO O ARDO PTIONSEXCHANG E

CHICAG BO O ARDO PTIONSEXCHANG E

March (3/31) S&P 500 Option Prices Price

CHICAG BO O ARDO PTIONSEXCHANG E

CHICAG BO O ARDO PTIONSEXCHANG E

Outcome #1 10% Drop SPX @ 1192.50

CHICAG BO O ARDO PTIONSEXCHANG E

Outcome #2 Flat Market SPX @ 1325.00

CHICAG BO O ARDO PTIONSEXCHANG E

Outcome #3 5% Gain SPX @ 1391.25

CHICAG BO O ARDO PTIONSEXCHANG E

1325 Put 1300 Put

CHICAG BO O ARDO PTIONSEXCHANG E

CHICAG BO O ARDO PTIONSEXCHANG E

CHICAG BO O ARDO PTIONSEXCHANG E

CHICAG BO O ARDO PTIONSEXCHANG E

CHICAG BO O ARDO PTIONSEXCHANG E

SPX Down 10% Up Flat5%

Long 1325 Put 132.50 0.00

Short 1350 Call 0.00 -41.25 0.00

Collar Cost -12.70 -12.70

SPX Profit/Loss -132.50 66.25 0.00

Total Profit/Loss -12.70 13.30 -12.70

% Profit/Loss -0.96% +1.00% -0.96%

SPX Down 10% Flat Up 5%

Long 1300 Put 107.50 0.00 0.00

Short 1325 Call 0.00 0.00 -66.25

Collar Credit +6.70 +6.70 +6.70

SPX Profit/Loss -132.50 0.00 66.25

Total Profit/Loss -18.30 6.70 6.70

% Profit/Loss -1.38% +0.51% +0.51%

CHICAG BO O ARDO PTIONSEXCHANG E

S&P 500 Summary