Volatility and Options 39 in C#

Recognizer Code 128A in C# Volatility and Options 39

important factors in option trading We focus a great deal on using high implied volatility in many of our strategies

To effectively demonstrate the new market volatility we are discussing, let s look at a few exceptional examples of recent volatility and massive price movement Figure 33 shows the CBOT soybean futures over four years or so with the most striking part of the chart beginning in September 2006 Soybeans began a rally based on fundamental crop issues and massive index and hedge fund buying that culminated in gains of over $1100 per soybean contract The margin on the CBOT soybean futures contract changes as market volatility increases risk, but futures margin requirements exploded during this period At-the-money call options during this period were a full $100 per bushel or more (5,000 bushel contract or $5,000 per

dollar per bushel) Some of the weeks displayed in this chart had 5, 10, or even 15 thousand dollars worth of trading range In Figure 34 we show what many consider to be the best market indicator for investor sentiment regarding the market This is not an indicator of market direction, just market sentiment The VIX index, or The Chicago Board Options Exchange(CBOE) volatility index, shows the average volatility of S&P 500 stocks By calculating the volatility of the options, the index represents the sentiment of options traders with respect to the next two option expirations In Figure 34 we have highlighted the section representing the fourth quarter of 2008 This very clearly shows the increased volatility across the full market if the fairly diverse group of stocks represented in the S&P 500 are experiencing this level of daily volatility Option volatility during the last half of 2008 was extreme in almost every market As we look beyond 2008 and to the rst quarter of

2009, we can see some resumption of range to the volatility, but if you imagine a midline in the volatility for the rst quarter, you are looking at something like 45 percent in comparison to the third quarter of 2008 at around 20 percent average volatility We must be prepared to adjust to this increased level of volatility on a more permanent basis and make a new level be a part of trade construction, portfolio management, and risk control If at some point in the future volatility returns to normal, we can use the lessons learned from high volatility to be even more effective in periods of low volatility Another interesting demonstration of volatility shows the reaction to volatility demonstrated by the VIX index in Figure 35 Figure 35 is a chart from the iShares 20-year bond fund in the same period as the VIX chart in Figure 34 During the last quarter of 2008 there was a large exodus of cash from the equity market into safety areas,

which is the cause of the large price spike in the Treasury fund We can correlate almost exactly the peak in the S&P 500 option volatility from the VIX chart to the beginning of a period of increased volatility and massive in ux of cash into the debt market As volatility reached exceptional levels, the risk tolerance and con dence of investors caused the movement of funds from equity to debt It is clear that as investors began to feel the exceptional volatility in equities, the liquidation of equity assets began, and the money had to move to safer areas It is important to study volatility not only in the market you are attempting to trade in but also in related and opposing markets as well

Volatility can occur as a result of a number of things, everything from quarterly earnings reports to crop conditions in Brazil In the case of the last quarter of 2008, volatility developed as a result of a mass exodus of cash from many markets as the credit crisis reached critical mass and investors began to ock to cash and safety In contrast to the equity volatility, commodities markets were experiencing increased volatility for several quarters prior to the fourth quarter for a multitude of reasons Increased energy demand and reduced supply created an environment in which energy product pricing created a ripple effect through every aspect of commodity production Producers, transportation suppliers, end users, and retailers all were affected The soybean chart in Figure 33 is a perfect example of how increased pricing and volatility cross into a storm of market uctuation Commodity options during this period saw a dramatic increase in premium because of the increased implied volatility Call option