Comments from Instructor: A detailed yet analytical paper, which puts class materials into good application, and takes one step further, if simple, to the real world.

I would focus on five topics in this paper: Put to Call Ratio: Bearish VS. Bullish Volatility: to forecast market activity Historical Volatility VS. Implied Volatility Volatility Smile VS. Volatility Skews Risk Reversal: to judge market positioning Collar: to help hedge the risks. How do we trade with this information?

call put Data Source: CBOE

Facts: According to data from CBOE (Chicago Board Options Exchange), the Put to Call ratio has an average of during the observed month-November The total volume of options is up to 57,588,085 for the year 2010, until Dec 3. Due to the fact that so many options are traded in one year, it is important for us to know the trading strategy for options in the derivative market.

The Put-Call Ratio is the number of put options traded divided by the number of call options traded in a given period. The average ratio is often far less than 1.00 (usually around 0.70) for stock options due to the fact that equity options traders and investors almost always buy more calls than puts. When the ratio is close to 1.00 or greater, it indicates a bearish sentiment. The higher than average number indicate more puts being bought relative to calls, which shows that more traders are betting against the underlying and thus the general position is bearish. Conversely, when the ratio is near 0.50 or lesser, it implies a bullish sentiment.

Definition: Volatility is a statistical measurement of the scale of fluctuation of a market or security. Volatility is calculated as the annualized standard deviation of daily proportion price changes of the security and is expressed as a percentage. As the volatility increases, the option premiums increase, i.e., the option prices goes up. A high volatility signals a strong demand for the call / put options.

Historical Volatility (HV): measure how volatility in the past (commonly use 20 days ≈ the number of trading days in a month). Implied Volatility (IV): is the market's opinion of the volatility of the option's underlying security and is determined using the following information: The price of the underlying security The market price of the option The strike price of the option The expiration date of the option The interest rate, if applicable The dividend yield, if applicable

Volatility Smile: A common graphical shape that results from plotting the strike price and implied volatility of a group of options with the same expiration date. (figure 1) In theory, for options expiring on the same date, we expect the IV to be the same regardless of which strike price we use to perform the calculation. However, in practice, the implied volatilities we obtain varies across the various strikes, giving rise to what is known as the volatility skew. Volatility Skews, is defined as the difference in implied volatility (IV) between out-of-the-money, at-the-money and in-the-money options. It is affected by sentiment and the supply/demand relationship, provides information on whether fund managers prefer to write calls or puts. (figure 2)

Volatility smile shows that traders are willing to pay higher prices when the strike prices of call or put options go aggressively out of the money. Figure by Yina Qiao

People are more likely to pay higher premiums for aggressively out-of-the-money call options. It is quite cheap for the out-of-the-money put options. Figure by Yina Qiao.

Risk reversals refers to a measure of the volatility skew. Risk reversal is not perfect, but can be used to judge market positions in the FX market and can convey information to make trading decisions; i.e., it can generate overbought and oversold signals It consists of a pair of options, a call and a put, under same currency, with the same expiration and sensitivity to the underlying spot rate, as well as the same implied volatility.

Risk Reversal = Implied Volatility on OTM Call – Implied Volatility on OTM Put e.g. R25 = σcall,25 − σput,25 A large positive risk reversal signals an overbought position; and a negative risk reversal implies an oversold position. In detailed, a positive risk reversal means the volatility of call options is greater than the volatility of similar put options, which implies that more market participants are betting on a rise in the currency than on a drop; in other words, there is an expectation of downward movement on the underlying currency. Vice versa if the risk reversal is negative (like the figure 2).

Source: DailyFX

Under the situation with a volatility skews like the figure 2 (volatility skews), most traders are betting on the drop in currency. If one also believes the currency price will drop, he should purchase the put option. One risk reversal could be buying an out-of-the-money put option and simultaneously selling an out-of-the- money call option, both with the same expiration date, but different strike prices. Use the substantial premiums gained from the sales of the call option to buy the put option. (i.e. long put +short call) We call this a collar position, i.e. Underlying – Risk Reversal = collar

E.g.) long put + short call Source: Option Maker © J.D. Han

Collar is also known as “hedge wrapper”. The purchase of an out-of-the money put option is what protects the underlying shares from a large downward move and locks in the profit. The price paid to buy the puts is lowered by amount of premium that is collect by selling the out of the money call. It is suited to the investor who has already owned the stock and are looking forward to: increase their return by writing call options minimize their downside risk by buying put options

Purposes of the trading system are: NOT to make money only To be able to identify trend as soon as possible To be able to find indicators to confirm your trends Example: Source: bforex

Method: Use put-call ratio to determine when the investing crowd may be getting either too bullish or too bearish Use volatility to forecast the market activity Use risk reversal to gauge market position Use collar to hedge the risk

Definition of Volatility: volatility.aspx volatility.aspx Definitions: Volatility Skews and Smile Definition: Risk Reversals Definition :Collar DailyFX: actual example of Volatility Smile ner/2010/10/20/Forex_Strategy_Corner_FX_Options_Risk_Rev ersals_Trading_Strategy.html ner/2010/10/20/Forex_Strategy_Corner_FX_Options_Risk_Rev ersals_Trading_Strategy.html DailyFX: rodriguez/ using-options-trade-currencies.htmlhttp://forexforums.dailyfx.com/david- rodriguez/ using-options-trade-currencies.html Figure 3 “Collar” is drawn by using Option Maker © J.D. Han Trading trend: rends%20and%20Trendlines rends%20and%20Trendlines Several information is taken from Wikipedia.