Celebrating 50 Years of Equity Options TradingAmid serious pushback, Chicago Board of Options Exchange (CBOE) went live on 26th April 1973. Options are now a standard tool for portfolio risk management. Not so, back then. They were seen as gambling instruments for reckless speculators.
Shortly after CBOE launch, Fischer Black, Myron Scholes, and Robert Merton provided a mathematical model for computing options prices.
This Nobel Prize winning model allowed options to be priced theoretically for the first time. It was a key driver in making options markets sophisticated, more efficient and much larger.
The Black Scholes Merton model ("BSM") forms the fundamental basis of options pricing. It allows traders to compute a theoretical price to options based on the underlying asset’s expected volatility.
Expected volatility is referred to as implied volatility (IV). Why implied? Because it is the volatility implied from an options price given other parameters from the BSM model.
COMPREHENDING BSM & BLACK76
Options have existed since the 17th Century. Option were limited to speculation and gambling in the absence of a sound and suitable pricing model such as BSM.
BSM offers a mathematically sound framework to compute theoretical price of European options using five inputs:
1. Underlying Asset Price
2. Implied Volatility (IV) of the Underlying Asset
3. Interest rates
4. Exercise (Strike) Price of the option
5. Time to expiry
A variant of the BSM for pricing options on futures, bond options, and swaptions is the Black Model (also known as Black76) which forms the basis of pricing options on commodity futures.
BSM is far from perfect. For starters, it makes unrealistic assumptions. Such as that stock prices follow a log-normal distribution and are continuous. That future volatility is known and remains constant. BSM assumes no transaction costs or taxes, no dividends from the stocks, and a constant risk-free rate.
Even though these assumptions are impractical, the BSM provides a useful approximation. In fact, the model is so commonly used that options prices are often quoted as IV. On the assumption that given IV, options price can be computed using BSM.
Actual options prices vary from theoretical ones based on supply-demand dynamics and with reality being different from the assumptions baked into BSM.
For instance, actual prices for the same expiry and at different strike prices have been observed to have different IV. Primarily given a higher likelihood of a downside plunge relative to upside rally. This difference in IVs across different strikes is referred to as volatility skew.
OPTIONS IN SUMMARY
Options involve two parties whereby one party acquires a right to buy or sell a pre-agreed fixed quantity of a stock/commodity at a pre-agreed price (the strike or the exercise price) at or before a pre-agreed future date (Expiry Date).
One party acquires the right (Option Buyer or Option Holder) and the other party takes on the obligation (Option Seller).
In consideration for granting the right, the Option Seller collects a premium (Option Price) from the Option Buyer.
To ensure that the Seller keeps up their promise to trade, such Sellers are required to post margins with the Clearing House.
Once buyers pay premium upfront, they are not required to post any additional margins with the Clearing House.
Where the Option Holder secures a right to buy, it is known as a Call Option. However, if the Option Holder acquires the right to sell, such an option is referred to as Put Option.
Where the Option Holder can exercise their right at or before any time before expiry, such Options are referred to as American Options.
Options that can be exercised only at expiry are referred to as European Options. While exercising is permitted at expiry, these European options positions can be closed out before expiry by selling out a long position or by buying back a short position.
Premiums for European options are typically lower than premiums compared to American options.
COMPREHENDING WALLSTREET’S FEAR GUAGE, FADING VIX, AND VIX1D
The CBOE Volatility Index (famously referred to as VIX and is also knows as fear gauge) is a real time index measuring the implied volatility of the S&P 500 for the next 30 days based on SPX Index options prices for options expiring in 23 to 37 days.
There are a range of financial products based on the VIX index allowing investors to hedge volatility risk in their portfolios.
In recent months, VIX has been fading into insignificance. Despite huge price moves in the S&P 500, VIX has remained staid. Why such inertia? Primarily because options markets have started to shift towards shorter expiries. Zero-Days-To-Expiry (0DTE) options now account for more than 40% of overall S&P options market volumes.
These very short-dated options allow traders to express views around specific events such as monetary policy meetings and economic releases. Their popularity has increased dramatically over the past few years, with volumes today nearly 4x that of 2020.
To account for this shift in market behaviour, the CBOE has launched the VIX1D i.e., the One-Day VIX. This index tracks the expected volatility over the upcoming day as determined by zero-day options prices.
More on Options Greeks and Risk Management using Options in a future paper.
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