Posts Tagged ‘volatility’

VEGA IMPACT IN OPTION PRICING FINAL PART :)

The Vega is highest in ATM option and slightly less at OTM and ITM options. The change in Implied Volatility will impact the most on the price of ATM option ascompared to the ITM and OTM options. The Implied Volatility can only impact the time value not the intrinsic value of the option so while comparing in betweenthe OTM and ITM options the OTM option’s Vega will be higher.

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The Impact of the Theta (time decay) to the Vega is negative. As the time passes if other thingremain unchanged the Vega decrease near to the expiration. As stated above the Vega valueis the most at ATM options and near to expiration the time value get decreased so does theVega. This is also called as Vega decay.

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The graph display that keeping all factors same(Volatility, price of underlying) the ATM Strikeoption of nifty the Vega on decreasing mode as it comes near to the expiration. When thedays left for expiration is 24days the Vega is 5.521 and 4.366 when it only 15 days are leftwhereas it is only 1.128 on the last day.There are various volatility strategies which options traders execute at the times of high/lowvolatility.

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For example, during times of earnings, elections or other major events thevolatility generally raise and to capture this opportunity the trader or investor buy strangle/straddle which is Vega positive strategy.Many traders time to time require adjusting their position to reduce the risk exposure in the market. This can be done by various ways it can be either adjustingvega with decreasing theta or adjusting vega with increasing the theta. If there is a large movement expected in the market then a buy call or put, debit spread,long strangle and long strangle adds the vega to the position but there will be risk of theta decay whereas on sideways market long ATM butterfly and long ATMcondor decrease the Vega as well as theta in the position.

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If the goal is to increase the vega and theta then the calendar spread, double calendar and Iron condorstrategy should be added to the portfolio whereas the sell iron condor, ATM Calendar and sell call or put are vega negative and theta positive strategies.In nutshell, the option trader/investor should understand the risks involved in it before entering into the trade and how the volatility impacts the position.Before entering into a trade one must have view about the direction and volatility. If there is an expectation of rise in volatility then long strangle, long straddle,debit spread, ratio and calendar spread should be followed whereas in expectation of fall in volatility one should go for short straddle, short strangle, creditspread, backspread and butterfly spread.

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VOLATILITY (VEGA) IMPACT IN OPTION PRICING Part 1:)

Options are non linear products, volatility being an important price determinant. Volatility can be looked at as a huge potential O reward as well as risk for the option traders. So why is volatility so important for option traders? Because, it tells the possible price changes of underlying in future. In this article we will try to understand what Vega is and how change in volatility affects the option pricing.

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Vega measures the sensitivity of an option to the Volatility of the underlying. How much option should lose/gain value with a movement in implied Volatility by 1%. To understand Vega we first need to understand Implied Volatility. Implied Volatility is the estimated or expected volatility of a security’s fair price which we derive from a model such as the Black-Scholes Model.

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In addition to required factors such as market price, expiration date, interest rate and strike price, implied volatility is also used in calculating an option’s premium. The most important factor in option trading is to manage the Vega as other factors are known to the investor/trader like time to expiry, spot and strike price and interest rate.

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It means that a call option trading @ 45 and having Vega of 0.47, if the Implied Volatility rises by 1% then the option value will be 45.47. An option price rises due to the expectation that increase in Volatility rise, with the possibility for an option to get expired in favor.

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Let’s understand Vega through simple option positions. Long Call and Put have the positive Vega whereas short Call and Put have the negative Vega. There is no Vega for the stock. Here, positive Vega means that raise in Implied Volatility favor the option. Negative Vega means that fall in Implied Volatility favor the option.

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Let’s take a simple example on S&P CNX Nifty options. In Nifty a Bear call spread for the expiry Aug2010 on 16 Aug 2010 where we short 5400 Call @ 95 whose Vegais 3.18 and Long 5500 Call @36 whose Vega is 3.38. The long call Vega is positive and short call Vega is negative. So the net Vega of this position is +0.20. If theImplied Volatility rises by 1% (keeping other factors same) the net premium of 59 will rise to 59.20 and on fall by 1% it will shed to 58.80.

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Let’s Wait for the fianl part 🙂

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Theta Value of Options Final Part :)

Continuing the final part from where i have stopped writing……………. 🙂

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At-The-Money options have the maximum time value, because intrinsic value can begin to rise at this point.

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.The graph here indicates that the (absolute) value of Theta is highest at 2.67 for Nifty 5400 Call, which is At-The-Money (ATM) strike (which is at present the closest strike to the underlying’s spot value), as the strikes move away from ATM, and gets deep into the money or deep out of the money Theta and time value tends to decrease.

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Coming to the relationship between time value and the length of time remaining to expiration, time value of an option decays at a non-constant rate, as its expiration date approaches and becomes worthless after that date. This rate of time decay is known as Theta, which measures the amount by which option’s value decreases per day.

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Theta values are negative for all options as options are always losing time value while moving towards expiration, till options take zero time value at expiration. At expiration Theta wipes out all time value leaving the options with no value or some degree of intrinsic value. The most important characteristic of Theta is that it is not constant, as date of expiration comes closer, Theta increases, implying that the amount of time value decreasing from the option’s premium per day accelerates with each passing day.

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As you can see from the graph the rate of decay (Theta) is lower in the contracts expiring in more distant months. The August 5400 Nifty call (which has 34 Days remaining to expiry), have a Theta value of -2.67; meaning this option is losing Rs.2.67 in time value each day. This rate of decay is lower for each forward month, e.g. September 5400 call (69 days remaining to expiration) has a Theta of – 2.12. But in case of the present July 5400 call option, (with volatility and price of the underlying held constant) the rate of loss of time value accelerates as the call option gets nearer to expiration (i.e., the rate of decay is much faster on the option near to expiration than with a lot of time remaining on it). With 6 days remaining to expiration Theta is -5.03, and with 1 day remaining to expiration value of Theta has increased to 8.32.

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Considering time value and its dependence on volatility, higher volatility gives rise to higher time value as increased uncertainty about underlying’s price near expiration, tends to increase Theta.

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In conclusion, while trading options one has to consider Theta decay risk carefully as the option price may fall exponentially near expiration. However option traders can turn time value decay into profits by trading net selling option strategies which always have positive position Theta as income will be generated through time value option premiums even if the underlying remains stationary and range bound and options expire worthless. Covered Call or Covered Put Writing, Calendar Spreads, Call or Put Ratio Spreads, Call or Put Credit Spreads, Short Strangle or Straddle and even simple Call Writing and Put Writing are few common option strategies which have positive position Theta.

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Theta Value of Options Part 1 :D

In this article we try to discuss how time decay affects option pricing over time, though it is considered a significant risk factor, understanding the dynamics of time decay in option itself may reveal how to use it for incurring profits. As we  already know, most options have  a limited life span, i.e. till its expiration date. The option expiration date is the date after which the option contract becomes void and right to exercise it no longer exists. For all stock options listed on the National Stock Exchange, the expiration date falls on the last Thursday of the expiration month (except when that Thursday is a holiday, in which case it will be brought forward by one day to Wednesday).

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Not only do options expire on the set expiration date they also keep loosing their value over time. This phenomenon of loosing time value overtime is called time value decay. The risk related to time value decay of option price can be hedged by choosing options which are to expire in more distant months, where there is longer time remaining to expiration. This can slow down the rate of decay but one has to pay higher premiums on forward month options, which subjects it to higher Delta risk of more loss from wrong-way price movement and higher Vega risk which can arise from adverse changes in volatility.

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.The graph displayed here clearly shows that keeping volatility and price of the underlying constant, for the same At-The-Money strike of Nifty 5400 Call, for different expiry months the premium increases as the time remaining to expiration increases. For September expiry, when there are 69 days remaining to expiration the premium is `211, as we move towards August expiry the premium has decreased to `143.20 as only 34 days are left to expiration. Finally comparing it with present month expiry of July the Premium is lesser at `69.15 when there are 6 days remaining to expiration (which also includes some intrinsic value).

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The premium or the option price paid to acquire any option has two components: intrinsic value and time value (also known as extrinsic value). The intrinsic value depends on the moneyness of the option. Only if the option is In-The-Money it will have intrinsic value. At-the-money options and Out-of-the-money options have no intrinsic value. The second component of the option premium is time value, the time value depends upon the length of time remaining to exercise the option, the moneyness of the option, as well as the volatility of the underlying’s market price. In case of In-The-Money options, the time value decreases as the option goes deeper into the money, for Out-of-The-Money options, as they have no intrinsic value, time value is the same as option price.

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Wait for the final part 😀

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VOLATILITY IN OPTION TRADING Final Part

Volatility Skew

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If we try to compute the volatility of an underlying by feeding in the required variables and the market prices of the options into the Black Scholes option pricing model, theoretically, options with same expiration date should have same implied volatility regardless of the strike prices we input.

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But in reality, the implied volatility we get across various strikes is different. This difference in volatilities across its respective strikes is known as volatility skew. When implied volatility is plotted against its respective strike price, the resulting graph can be a U-shaped or downward sloping.

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Volatility Smile, Reverse Skew, Forward Skew

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If the plotted graph is a U-shaped curve, as shown in Figure 1.1 below, this volatility skew pattern is also referred to as a volatility smile as it resembles a smile.

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The U-shaped volatility smile skew pattern is common for equity options which are near-term and options in the forex market. Volatility smile indicates that the demand is greater for options that are in-the-money or out-of-the-money.

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But, for longer term equity options and index options the reverse skew patterns are typical (Figure 1.2). In the reverse skew pattern, the implied volatility of options at the lower strikes is higher than the implied volatility at higher strikes.

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This reverse skew pattern implies that in-the money calls and out-of-the-money puts are more expensive and more in demand as compared to out-of-the-money calls and in-the-money puts.

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This pattern can arise in two cases; either, when the investors are worried about market falls, so they hedge their positions by buying puts for protection, or the other explanation can be, that in-the-money calls have become alternatives to outright stock purchases as they offer leverage and hence increased return on investment. In both cases greater demand is created for in-the-money calls and therefore it results in increased implied volatility at the lower strikes.

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As against reverse skew, forward skew is another type of the volatility smirk (Fig. 1.3), where, the implied volatility for options at the lower strikes is lower than the implied volatility at higher strikes.

In this case, the out-of-the-money calls and in the-money puts are in greater demand as compared to in-the-money calls and out-of-the money puts. The forward skew pattern is common for options in the commodities market where there can be a supply crunch, business houses would be ready to pay higher prices to secure supply than to risk supply disruption.

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Concluding, for option traders the best market direction assessment and option price evaluations can only be drawn by inter comparison of implied volatility with historical, current and forecasted volatilities, by assessing if they are over or under priced.

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This is the Volatility Smile of Nifty as on at the market closing of 11th June 2010. As mentioned above it is a typical long term index option, with the reverse skew pattern.

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VOLATILITY IN OPTION TRADING Part 1 :)

We calculate an option’s theoretical value by using option pricing models, two of the primary, well know models are the ‘Black-Scholes Model’ and the ‘Binomial Model’. To compute the value minimum five of the option and its underlying’s related variables are required to be fed in these models; these five necessary inputs are the option’s exercise price, the time remaining to expiration, the current price of the underlying, the risk free interest rate over the life of an option and the volatility of the underlying.

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Out of the above mentioned inputs, volatility plays an important role in actual trading situations. Volatility is a statistical measurement of the degree of fluctuation of a market or security. Volatility is computed as the annualized standard deviation of daily percentage price changes of the security and is expressed as a percentage. Changes in our assumptions and marketplace assessments about volatility can have significant effect on an option’s value.

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Though the option traders are affected by the direction of the market, they are extremely sensitive to the speed of the market. This speed of the market is measured through volatility. In low volatility markets, the market of the underlying fails to move at a sufficient speed, and therefore, the options on that underlying will have lesser probability to achieve the option’s exercise price or the strike price within its expiry. But in markets which move quickly or in other words, in high volatility markets the market of the underlying is likely to move at sufficient speed and accordingly options on that underlying will have greater probability to achieve the option’s exercise price within expiry.

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Every Option trader is well acquainted with three types of volatilities- Historical Volatility, Forecast Volatility and Implied Volatility (IV). Historical volatility measures how volatile the security has been in the past. We compute historical volatility over a defined historical period, which is usually a twenty day period as it approximates the number of trading days in a month. Forecast volatility is an attempt to forecast directional moves in the price of the underlying, i.e. future volatility; it is usually calculated using time-series methods.

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Finally, implied volatility of an option contract is the volatility implied by the market price of the option derived from an option pricing model. In other words, it is the volatility that, when fed in a particular pricing model, yields a theoretical value for the option equal to the current market price of that option. This means it is possible to have a unique implied volatility for each given market price of an option. This implied volatility is best regarded as a rescaling of option prices which makes doing comparisons between different strikes, expirations, and underlyings easier and more spontaneous.

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PORTFOLIO REBALANCING TO STAY ON TRACK

Portfolio re balancing is the process of bringing the different asset classes back into appropriate proportion following a significant change in one or more.
PORTFOLIO REBALANCING TO STAY ON TRACK
Over the time, as different asset classes produce different returns, the portfolio’s asset allocation changes. To recapture the portfolio’s original risk and return characteristics, the portfolio must be rebalanced to its original asset allocation.

The primary purpose of rebalancing is to maintain a consistent risk profile. Periodic rebalancing will help to avoid counterproductive temptations in the market.

For example, in this seemingly falling market, rather than an investor

Tempted to follow the crowd, who are busy dumping popular stocks; the imbalance created by erosion of the equity component can be used to book profits on debt portion and buy into equities to bring back the allocation to the original ratio.

The balancing act

To get the entire asset classes back to their original allocation percentages would entail the following:

·Selling part of the equities and investing the proceeds into debt and cash and vis-a-versa.

·Putting in fresh one-time investments into debt and cash to raise the allocation in the portfolio.

·Start a systematic investment plan skewed towards debt and cash.

Rebalancing controls risk

The investments in a portfolio will perform according to the market. As time goes on, a portfolio’s current asset allocation can move away from an investor’s original target asset allocation.

If left un-adjusted, the portfolio could either become too risky, or too conservative.

The goal of rebalancing is to move the current asset allocation back in line to the originally planned asset allocation.

How often should one rebalance?

Though the frequency is entirely dependent on the investor, the portfolio size as well as market conditions will impact the overall returns’ expectation of the portfolio.

The main idea is that the periodic interval between successive rebalancing acts should be constant.

Some of the other factors affecting the rebalancing are:

Cost of transactions

If one decides to rebalance the portfolio once in six months, he needs to factor in short term capital gains, brokerages and entry exit loads. Hence, it is advisable to rebalance annually the long term portfolios and rebalance semi annually for the short term portfolios.

Volatility

High return volatility increases the fluctuation of the asset class weights around the target allocation and increases the risk of significant deviation from the target.

Greater volatility implies a greater need to rebalance. In the presence of time-varying volatility, rebalancing occurs more often when volatility rises.

Investors can also employ another trigger for asset rebalancing. They can decide to rebalance their portfolio, not according to time, but rather only when any asset class changes in allocation due to market movements, over a certain percentage.

Conclusion

Portfolio rebalancing is an important part of sticking to your game plan. You should look at your portfolio at least quarterly in terms of rebalancing and more frequently if you have had a significant gain or loss in any asset class.

At last asset rebalancing is a very important exercise for any disciplined investor who wishes to approach their investing in a systematic manner, while realizing their financial goals that they have set out to achieve.

Portfolio rebalancing is the process of bringing the different asset classes back into appropriate proportion following a significant change in one or more. Over the time, as different asset classes produce different returns, the portfolio’s asset allocation changes.

To recapture the portfolio’s original risk and return characteristics, the portfolio must be rebalanced to its original asset allocation.

The primary purpose of rebalancing is to maintain a consistent risk profile. Periodic rebalancing will help to avoid counterproductive temptations in the market. For example, in this seemingly falling market, rather than an investor tempted to follow the crowd, who are busy dumping popular stocks, the imbalance created by erosion of the equity component can be used to book profits on debt portion and buy into equities to bring back the allocation to the original ratio.

Future Venture to Re-File for IPO Soon :)

future group

Future Venture is likely to approach Sebi again for an initial public offering soon, as the validity of the earlier approval by the market watchdog lapsed this month.

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“We are going for a fresh filing (for IPO) with Sebi,” Future Group Chairman Kishore Biyani told PTI.

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The company, which is a part of diversified Future Group, had received the Securities and Exchanges Board of India (Sebi) approval for IPO on September 4, 2008.

As per regulations, a company has to hit the capital markets within 12 months of receiving the Sebi nod.

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Last year, the company had planned to raise up to Rs 1,000 crore through a public offering of about 374 crore shares so as to fund the group’s expansion plans.

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However this time amount to be raised from the capital market would be less than the previously planned Rs 1000 crore.

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Liquidity crunch and volatility in recent times had forced many companies including Future Venture to either postpone or shelve their plans to mop up funds from the capital market.

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“The planned IPO by Future Venture was actually a by-product of the bull market.”

“After the success of Future Capital IPO last year, the Future group thought of tapping the capital market with another offer, although there was no actual necessity of fund raising,” SMC Capital Equity Head Jagannadham Thunuguntla said.

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The Future Group, which is into various businesses apart from retail, is currently looking at ways to raise funds.

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uture Venture is likely to approach Sebi again for an initial public offering soon, as the validity of the earlier approval by the market watchdog lapsed this month.

🙂

“We are going for a fresh filing (for IPO) with Sebi,” Future Group Chairman Kishore Biyani told PTI.

🙂

The company, which is a part of diversified Future Group, had received the Securities and Exchanges Board of India (Sebi) approval for IPO on September 4, 2008.

As per regulations, a company has to hit the capital markets within 12 months of receiving the Sebi nod.

🙂

Last year, the company had planned to raise up to Rs 1,000 crore through a public offering of about 374 crore shares so as to fund the group’s expansion plans.

🙂

However this time amount to be raised from the capital market would be less than the previously planned Rs 1000 crore.

🙂

Liquidity crunch and volatility in recent times had forced many companies including Future Venture to either postpone or