contracts can be traded on a variety of financial instruments.Foremost among these is the single stock option, an option written on onespecific underlying stock. There are also index options written on a variety offinancial indexes such as the Standard & Poor’s (S&P) 500, the NASDAQComposite, or the Dow Jones Industrial Index. Options contracts are alsowritten on foreign currencies. The underlying financial instrument is a unit ofthe foreign currency such as a Canadian dollar or a German deutsche mark.If you believe that the value of the foreign currency is going to appreciate, youcan buy a call on the currency, and if you are right you will make the differencebetween the strike price and the new price of the currency (less the premiumpaid). Finally, there are options on futures. In this case the underlying instrument is a futures contract. Futures contracts can be written on a large number
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of goods. Many futures contracts are written on agricultural goods, preciousmetals, financial indexes, and foreign currencies. Unlike equity all optionscontracts, the purchaser of the futures contract has an obligation to purchasethe underlying instrument for a specified price for a specified length of time.In an options transaction the buyer of the option contract pays the sellera premium for the right to call away (buy) the underlying shares of stock at aspecified price for a certain length of time (in a call transaction) or to force theseller to purchase the underlying shares from the purchaser at a specifiedprice for a certain length of time (in a put transaction). Subsequently, there isa greater risk of loss for the seller of the option contract than there is for thepurchaser. The greatest amount of money that the buyer of the option contractcan lose is limited to the premium that he or she pays for the contract. Conversely, the seller of the option can theoretically have unlimited losses in specific situations. When the seller of a call option does not own the underlyingsecurity, he or she is known to have sold (or “written”) a naked call option.This position creates the single greatest potential for losses in options trading.For example, if a call was written on a stock with a strike price of $20 for a $3premium and the price of the underlying stock climbs to $50, the writer of thecall would lose $30 less the $3 premium that he or she was paid. In this transaction, the purchaser of the option contract would call away the underlyingstock from the seller and pay him $20 per share for the stock. Remember, theseller of the option does not own the underlying security, so she must go outinto the open market and purchase the shares for $50 apiece. It is importantto note that each stock option contract controls 100 shares of the underlyingsecurity. Thus, it is easy to see how quickly the losses can add up when sellingnaked calls. If the seller had sold 10 contracts, the buyer would have the rightto purchase 1,000 shares of the stock at $20 and the seller would have lost$27,000 ($50 minus the $3 premium, minus the $20 he or she received from thebuyer, multiplied by 1,000 shares). This is obviously a very risky position totake because theoretically there is no ceiling for your losses—a stock’s pricecould rise to an unlimited value. Similarly, the purchaser of a call option conceptually can experience unlimited gains. The easiest way to explain the overall strategy for options is that buying a call is much like going long the underlying security, and buying a put is similar to going short the underlyingsecurity. If you believe the price of the underlying stock is going to appreciate,you would want to buy a call option. If you believe that the price of the underlying stock is going to decrease, you would buy a put option. Meanwhile, anoption seller is simply trying to generate the option premiums. It is much saferto be the buyer of any option than to be the seller, except for when you arewriting covered calls, which will be discussed later in the chapter.
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Writing put options is also a very risky proposition, but there is a limit tothe losses that the seller can sustain. Since a stock’s price cannot sink below$0, the most a put writer can lose is the exercise price of the option less thepremium they received. If a put was sold with a strike price of $20 and theseller received a $3 premium, then the most they can lose would be $17 pershare. This works the same way for the purchaser of the put option—his orher gains would be limited by the difference between the exercise price andzero, less the premium paid.The price of the premium paid for an option contract varies accordingto several factors. First and foremost is whether the option is in-the-moneyor out-of-the-money. These terms relate to the current price of the underlying stock (or index, future’s contract, etc.) in comparison to the strike priceof the option. For a call option the contract will be in-the-money if the current price of the stock is above the strike price for the option. Referring toour previous example, a call option is written with a strike price of $20. Ifthe price of the stock is above $20, the option contract is considered to bein-the-money. This is because the owner of the contract could exercise thecontract at that time and would receive a gain of some magnitude. Ofcourse, the contract owner had to pay a premium for the option contract,so in our example with a $3 premium having been paid, the stock wouldhave to be trading above $23 for the contract owner to make a profit on thetransaction, although if the stock were trading between $20 and $23,the option owner could still recoup some of the premium paid by exercising the option. For a put contract the relationship is reversed; if the price ofthe stock is below the strike price of the contract, the option is consideredto be in-the-money. If a put contract has a strike price of $20 and the stockis trading at $15, the owner of the put could go out in the open market andpurchase the underlying stock for $15, and the seller of the put would haveto purchase the stock from the option owner for $20, thereby locking in aprofit for the owner.The opposite is true for an out-of-the-money option contract. A calloption is out-of-the-money when the price of the underlying stock is belowthe exercise price of the option. This contract would not be exercisedbecause the underlying stock could be purchased in the open market for lessthan the contract owner would have to pay if he or she exercised the option.Similarly, a put contract is out-of-the-money if the price of the stock is abovethe strike price of the option contract. It would not make sense to exercisethis contract either, because the contract owner would be purchasing thestock in the open market at a higher price than he or she would receive fromthe contract seller. Buying high and selling lower is not a very good strategyto make money by trading options.
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There are really two components to the premium price of an option:extrinsic value and in-the-money value. Extrinsic value is simply the conceptthat the farther away the contract expiration date, the more valuable theoption. This is because the price of the underlying stock has the probability ofmoving to a much greater extent over a longer period of time. An option contract that has two weeks to expiration is much less valuable than one with twomonths to expiration (neglecting for a second in-the-money issue). The second component to option premium pricing is the in-the-money value. If anoption is in-the-money, the option seller must be compensated for that value.Otherwise (in a vacuum, but not reality), traders would simply purchasein-the-money contracts, immediately exercise them, and take a profit on thetransaction. Once again, we will use the prior example of an option contractwith a strike price of $20. If the stock is trading at $25, the premium for theoption will have to be at least $5 to make up for the guaranteed gain. Mostlikely, unless the option is at expiration, there will be an additional amountadded to the in-the-money amount to account for the intrinsic-value aspect.There are a few other things that can affect the premium charged for anoption. The volatility of the underlying stock has a lot to do with premiumpricing. A high-volatility stock, say with a standard deviation of 30 percent,would have a much higher premium than a lower volatility stock with a standard deviation of 10 percent. The reason for this is similar to the time-valueconcept; the high-volatility stock has a much greater probability of experiencing dramatic price swings than the lower volatility stock, and consequentlycreates a greater risk of loss to the option seller. As with any situation in theinvestment world, risk must always be compensated. One final note on optionpremium pricing: Generally, the higher the price of the underlying stock, thehigher the premium price for the option, all else being equal.As previously mentioned, there is a safe income-producing strategyknown as covered call writing. A covered call is the term given to the situation in which the call writer actually owns shares of the underlying security(in proportion to the number of call options they have sold). The call writerreceives the premiums from the purchaser and if the stock gets called awayfrom him he will also receive the exercise price of the call option. The riskin this transaction is purely the opportunity cost if the stock’s price rises andit gets called away. The call writer will not actually lose any money becausehe can simply deliver the stock that he already owns, but he will miss out onthe gains that would have been attained had he still owned the underlyingstock. For that reason, most writers of covered calls hope that the stock’sprice remains around the exercise price of the calls so the option will expireworthless. That way, the covered call writer receives the premiums paid andstill gets to keep the stock.
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Another fairly basic options strategy is referred to as a straddle. A straddle occurs when a call and a put are bought with the same exercise price andthe same expiration date. The purpose of a straddle is that the owner shouldmake money if there is any price volatility, regardless of the direction of themovement. If both a call and a put are bought with a strike price of $20 andthe stock price either gains or loses $5 in value, the owner of the straddle willface the same payoff profile whether the stock price moves up or down. If thestock price advances to $25 and the call option is exercised, the option ownerwill make $5 (disregarding the premiums paid) and the put option wouldexpire worthless. If the stock price declines to $15, the put option would bein-the-money by $5 and the call option would expire worthless. Unfortunately, if the stock price remains relatively unchanged both the call and theput option will expire worthless. It is for this reason that the straddle strategy is most effective when used with high-volatility underlying stocks. Thehigher-volatility stocks by nature have a greater probability of price movement and this increases the probability that one side of the straddle will finish in the money. One application of this strategy is, using technical analysis,to buy a straddle with an exercise price that corresponds to a support orresistance level for a stock. That way, whether the stock breaks out or pullsback, as long as there is some price movement, your straddle will finish inthe-money.Options trading has many applications in the investment world and is auseful tool to leverage your money, to hedge a portfolio, and for risk management purposes—usually used by financial institutions. The last majoradvantage of trading options is that options do not have symmetrical payoffprofiles. You can limit your downside risk by purchasing options rather thanthe underlying stock because when buying options the maximum amountyou can possibly lose is the price of the option premium. When purchasingstocks your maximum loss potential is the price of the stock, or all themoney that you have invested. It is even worse if you are shorting stocksrather than buying puts because, as we discussed previously (when talkingabout selling calls), the potential loss is theoretically unlimited since stockshave no ceiling above which they cannot rise. Trading options can be a verylucrative investment strategy, but it should be approached with caution. Ifyou are writing calls and puts, you can quickly get yourself into a dangerousloss position, and if you are buying options, you can end up paying a lot ofmoney in premiums and have your options expire worthless. It is a good ideato educate yourself about the process as much as possible and then to practice by paper trading before you actually start working with real money.
CHAPTER 25
UnderstandingVolatilityWhat Is Volatility?Volatility Position Sizingin Your SpreadsheetVolatility and theIndividual StockWeighted Volatility
WHAT IS VOLATILITY?To begin, the definition of volatility is generally known as the speed of themarket. (EN 25.1) By this, volatility is known as the speed at which yourposition moves up or down. Volatility is the percentage change of the stockover a given period of time. A stock that moves 2 points in two years has lessvolatility than a stock that moves 20. Though this concept is extremely simple, you will soon see that it has a wide variety of uses when trading pairs,stocks, and/or equities.To further expand on our definition, volatility is known as the time ittakes for a position to move. Volatility can also be incorporated in our statistics to provide a better indication of our position sizing, along with helping us decide what types of option strategies to implement.
VOLATILITY POSITION SIZING IN YOUR SPREADSHEETVolatility can be a little confusing at first, as some can mistake the conceptas an absolute percentage changes over a period of time. However, this isincorrect. Instead, volatility is a concept of speed that can have either apositive or negative impact. When we look at our KLAC/NVLS spreadsheet(titled KLAC-NVLS-Volatility on the CD-ROM), you will find the simple oneyear volatility number located in each individual stock’s worksheet and the201
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Volatility worksheet. In the Volatility worksheet you will find the actualnumbers in cells F4 and G4. The volatility numbers in this case monitor thelast year’s percentage change, and will update itself with each new day ofdata added. Thus, the numbers encompass the past 256 days of trading, orone year of change.While the numbers are a percentage change, we will instead view them asa standard deviation of movement of the stocks from the mean. In terms ofspeed, KLAC’s volatility over the last year was 12.30 percent and has a meanprice of $51.16. Thus, if we multiply 12.30 percent by $51.60, we come up with6.34. Given the last year’s trading range, we can anticipate that in the followingyear, the stock will trade at ⫹/⫺6.34 points of $51.60. This would equate to onestandard deviation, while two standard deviations would amount to the stocktrading at ⫹/⫺12.68 points of the mean. Now, looking at NVLS, we see that thestock has a one-year volatility of 5.79 percent, with a mean of $44.58. We caninfer that over the next year (given the last year) the stock will have a one standard deviation trading range of ⫹/⫺2.58 points of the mean. Figure 25.1 showsthe Volatility worksheet with the data that we have uncovered thus far.It is important to remember several things here. First, we are looking atpercentage changes as a measure of volatility. This measurement is notincorporating past data of two, three, or even five years. Thus, we are reallyonly looking at the volatility of the stock in the recent (one-year) trend.Why is this so important? Think about it—the volatility for KLAC is just
FIGURE 25.1 Volatility
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over 12 percent; however, if we look all the way back to the top of the bullmarket and 2000, we see a different picture. The volatility dating to December 31, 1999, is ⫺5.51 percent. When adding and subtracting the negativenumber to our mean, the volatility of the stock has been greater over the lastyear, than the last three years. (However, please keep in mind that this isnot accounting for adjusted prices, which include splits and dividends.)What we can also surmise at this point is that the speed—or volatility—ofKLAC is much faster than that of NVLS. This is important, as in our pair, wecan assume that the stock with greater volatility—usually the more expensive stock—will move faster than the other. If our position is hedged on aneven level, we can assume that the end result could leave us with one sideof our trade overtaking the other on an uneven basis. This whole conversation is leading us to a ratio for our position on a volatility basis for positionsizing. If we simply divide the volatility of the two stocks, we can find a simple measurement of position sizing to help guide our trade. In the case ofKLAC and NVLS, we would divide 12.30 percent by 5.79 percent. Our conclusion is that we would take on 2.12 shares of NVLS for every one share ofKLAC (shown in Figure 25.2). This is substantially different than our simpleratio of 1.61. However, given the speed of the trade, NVLS will move muchslower than KLAC and thus deserves a larger position. This will mostly applyto options, which we will cover in the next chapter.
FIGURE 25.2 Main Spreadsheet
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VOLATILITY AND THE INDIVIDUAL STOCKTo understand the daily volatility of each stock, we can use some simplemath devised by Sheldon Natenburg. If we assume that the volatility ofKLAC is roughly 12 percent, we can find an interesting result by dividing thesquare root of one year’s worth of data by our aforementioned number. Todo so, we would assume that there are 256 trading days in the year, of whichthe square root is 16. Then by dividing 12 percent by 16 we receive 0.75.What this means is that one standard deviation of each day’s volatility—given the last year of trading activity—would equate to a ⫹/⫺75 cent pricechange. Two standard deviations would equal $1.50, while three would comeout to be $2.25. If at any given time, KLAC is trading up or down $2.25, wewould surmise that the stock is trading at the outlying third standard deviation of its recent historical activity. On an intraday basis, if we scan ourKLAC worksheet to find trading days when the stock closed above or below$2.50, in terms of intraday change, we only find 17 instances that it did so inthe last 1,699 trading days! This means that if you either bought or soldKLAC when the stock was up/down $2.50 since January 2, 1996, you wouldhave lost exactly 1 percent of the time. However, the losses on these daystranslate to just a few cents all the way to several dollars. The fundamentalconcept, though, is that by understanding the stock’s volatility in terms ofdaily change, we have an opportunity to make money on an intraday basis.Where does this help the pairs trader? If you were to buy or sell KLAC when,on a volatility basis, the stock is trading at the third standard deviation ofdivergence, you have a good win/loss percentage basis to make money.What’s more, if instead of taking a regular position, you had paired up withNVLS, you would have hedged your position for an intraday pairs trade. It isimportant to remember that we are looking at the volatility of the fastermoving stock, as we want to make sure our lagging—or hedged—position ismerely a complement to the directional trade. Please keep in mind that oncertain days when KLAC had major news moving the stock, it would nothave been a good idea to trade. However, if there were no major news, taking a position based on the statistical volatility would have been a goodmove. The entire point of this chapter is that by understanding the volatilityof an individual stock, we can find pairs divergences, without looking at thelonger-term statistics of the “pair.” If the pair has diverged on a long-termbasis, however, and we wait for an intraday divergence in terms of volatility,we increase our chances of having succeeding by that much more. One lastside note, the same sort of calculation can be applied to weekly volatility byusing the square root 7.2 as a divisor.
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WEIGHTED VOLATILITYTo forecast volatility we simply figure out what the historical volatility wasfor different time frames and then average the result. To do so, you willwant to figure out what the volatility is for 30-, 60-, 120-, and 200-day periods. Once you know what the volatility is for different periods, you can thenaverage the sum to gain a mean weighted volatility and then apply our normal statistics. The interesting part of volatility is that it always begins atzero for any given period and then moves either up or down. Thus, in termsof volatility, the concept is always mean reverting, as our foundation isalways zero. To get a more accurate picture of volatility, you will want toactually weight the periods measured to gain a more accurate picture. As anexample, we will use the same periods described above, along with thehypothetical return for each.Stock 130 days60 days120 days200 days
20%15%26%30%
FIGURE 25.3 Weighted Volatility
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The simple mean volatility is 22.75 percent for all periods covered.Because we want to give more weight to the most recent numbers, wewill actually divide them by a percentage to have a better understanding ofwhere our pair is.[(40% * 20%)⫹(30% * 15%)⫹(20% * 26%)⫹(10% * 30%)]The weighted mean return for the periods covered is 20.7 percent, whichis less than the simple average for the periods covered. To apply this to ourpair, we can measure different periods, and then weight the pair’s volatilityto have a better understanding of where the pair is. On the Main worksheet,you will find each individual stock’s weighted volatility in cells I23 and K23.Looking at the KALC/NVLS spreadsheet (Figure 25.3), we now know thatthe weighted volatility for both stocks is lower than the simple volatility.Though the volatility ratio in the worksheet is not configured forweighted volatility, the information is there and you can change the ratiofrom a simple ratio to weighted. However, this preference differs from traderto trader, with both numbers providing guidance for pairs trading.
CHAPTER 26
UnderstandingVolatility andOptionsSpeed and Option PremiumsOption Strategies for PairsCalls/Puts, Covered Calls/Puts
SPEED AND OPTION PREMIUMSSo why all this talk about volatility if it doesn’t apply directly to your pair?Volatility does, and when taking option positions, if we understand the speedof the two stocks that we are using, we will be able to better determine whattypes of positions to take. When using options, we want to make sure that wehave appropriate risk with the volatility of the position. If a stock is highlyvolatile, then we may want to use less risky strategies like butterflies andstrangles, which have opposite price reaction to volatility. The point ofvolatility as we use it in relation to our pairs is to understand what types ofpositions we should take given the amount of time left to expiration. If thereare only three weeks left to expiration for a contract and the 30-day volatilityranges from 0 to 5%, then we can assume that the risk for taking a pairs position based purely on buying puts and calls would be much more risky than aposition that has much higher short-term volatility. In the case of KLAC/NVLSwe can see that the 30-day volatility is ⫺0.30 percent and ⫺14.30 percent,respectively. We would infer from this data that buying a KLAC call and anNVLS put would have much more risk of expiration worthless for KLAC thanNVLS. Why? NVLS is clearly showing much greater near-term volatility thanKLAC. In other words, KLAC has been much more stable over the last 30 daysthan NVLS. What’s more, this data coincides with taking a larger position inNVLS than KLAC, as it is more likely to actually move into the money thanthe latter stock. We are using our volatility data to understand how quicklyeach stock will move. There is conflicting data here, though, as historicallyKLAC is not only more expensive, but also almost twice as volatile. However,207
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in the near term—what we are concerned with—the NVLS contract has a better chance of moving toward our strike price than KLAC. There is a contraryargument here that because NVLS has been moving faster than KLAC, it willbegin to slow in the future, as KLAC actually begins to pick up more speed.However, I have generally found that taking a larger position based on the historical simple average, coupled with near-term speed, can benefit a position.What is critically important to remember is that the higher a stock’s volatility,the more expensive an option is. The seller of an option knows that greatervolatility means increased risk. If you are the buyer, that means a moreexpensive premium.
OPTION STRATEGIES FOR PAIRSPairs and options can quickly get very complicated and have many differentcombinations of positions. To keep it simple, we will use only a few positionstrategies for our pairs. For further reading, I highly recommend OptionVolatility and Pricing by Sheldon Natenburg. (EN 26.1) Mr. Natenburg givesa much deeper understanding of volatility and more complicated strategies,such as Delta Neutral trading. As a brief side note, over the next chapter, asI speak of buying calls or puts, please assume that I am talking about buyingat-the-money positions. At-the-money positions move more like the actualstock itself, and involve slightly—and I would like to reiterate slightly—lesscomplicated decisions.
Calls/PutsThe simplest strategy for our pair is simply to buy calls and puts for each sideof our pair. In the case of KLAC/NVLS, we would buy two NVLS puts for everyone KLAC call in the position. However, we will begin to find the strategy complicated as we try and figure out what our premiums are and how far out of themoney we should purchase each side. Thus, as mentioned earlier, our best betmay be to simply purchase at-the-money calls and puts. By doing so, theoptions will trade more like the actual stock. Our risk is that the options willnot move far enough in-the-money to actually provide a profit; however, by purchasing options, we have limited our risk if the pair continues to expand.
Covered Calls/PutsIn a neutral market, a trader can implement a covered call to hedge risk. Thestrategy is simply to buy the actual stock, while selling call options against
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it. We would use this when we want to go long the stock and have immediate income. By executing a covered call on the long side of our pair, wewould receive the immediate income from selling the call. What’s more, ifthe stock rose, we would then also make money on the distance from wherewe bought the stock and the strike at which the call was sold. Once the stockrises above our call strike, on expiration we would be obligated to then handover the shares to the call buyer if he or she decides to exercise the position.Conversely, we could also write covered puts on the opposite side of thepair, understanding that if the pair completely converged, we would havelimited upside to the trade. However, if the pair continued to expand, wewould be short and long both positions further at a higher differential. Thereason this strategy is good for pairs trading is that it allows us take a“hedged” position, and raises (on the sell side) and lowers (on the buy side)our cost basis should the rubber band continue to grow. Let’s actually seehow this would work in terms of a pair. Suppose that our KLAC/NVLS position has expanded to a point where we believe that the rubber band has fullydiverged. We would like to take a position, but are unsure whether the pairhas reached a point where it will begin to reconverge. Just to clarify, the following example is completely hypothetical and does not use real prices; itis just for the sake of explanation.Our KLAC/NVLS spreadsheet is updated through October 10, 2003. Thedifferential is currently 22.13, while the ratio is 1.61. The pair (in differentialand ratio) is trading just above two standard deviations. Normally, I wouldwait for the pair to expand much farther before taking a position. However,by implementing a covered call and put at this point, I would then leave
FIGURE 26.1 KLAC/NVLS
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myself extra room for divergence. KLAC is trading at $58.60, while NVLS ispresently at $36.47. The pair is on the sell side of the mean, indicating thatwe would want to sell short KLAC and buy NVLS. Figure 26.1 brings us up tospeed on where the pair is for the current scenario.What we immediately notice is that in terms of regular standard deviations from the mean, if the pair were to open up to the third standard deviation, we could lose almost nine points by simply buying and selling the individual stocks. But by implementing a covered call and put and collectingpremium, we would have the opportunity to engage the pairs position atalmost 2.5 standard deviations, thus allowing us to actually take the positionat better prices. Thus, we would buy the actual NVLS stock and write a callagainst it, potentially $1 to $5 out-of-the-money. On KLAC, we would sellshort the stock, while writing a put against it, also $1 to $5 out-of-the-money.On both sides of this trade, we are hoping that the options will expire worthless and we will be left with the normal stock at better prices. It is extremelyimportant to remember that this strategy has much higher transaction costs,which could quickly erode all premium and profits. Also, our risk is still justas high for the trade in the sense that we are left with naked stock in the end,where we are still left with substantial risk. If you can shoulder the transaction costs and understand the risks involved, covered calls and puts are definitely a very interesting strategy using pairs.
CHAPTER 27
Using TechnicalandFundamentalAnalysis withPairsTechnical AnalysisMoving AveragesStochastics and OtherIndicatorsVolumeFundamentalsPrice-to-Earnings (PE) RatioPrice-to-Sales RatioKBH Homes and Tol BrothersMoving Averages and Supportand Resistance as Stops
f ter many years of hard lessons, I would like to pass some of myknowledge on. I hope that what I am going to tell you will give yousome insight into picking entry and exit points in your trades—outsideof statistics. The problem with statistics is that even though they are amazingat helping us determine relationships, and assisting in finding entry/exitpoints, two standard deviations tell us nothing about when a company hasaccounting problems. Take Enron, for example. If you had been pairs ordirectional trading Enron a few years back, and you thought the stock hadsome sort of “correlation” that would bring it back to the mean when itbegan to nosedive, you most likely lost everything.Thus, this chapter is to help us tie our pairs data into real decisions thatare presented in everyday investing. While the foundation of pairs lies within
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descriptive statistics, we must use all other facets of knowledge to help usmake our final decisions. In addition, descriptive statistics don’t alwaysgive us exit signals or concise stop loss points. Thus, by using technicaland fundamental analysis as a guiding tool of market direction, we can helpdefine our trade targets and stops.Along with technical analysis, we can also use fundamental analysis tohelp determine the valuation of the trade. While this may sound a little complicated, don’t sweat it. What we’re about to cover is actually very