Imagine that you're reviewing "Chapter 37: How Volatility Affects Popular Strategies" in McMillan's OPTIONS AS A STRATEGIC INVESTMENT or reading it for the first time. You come across the section discussing bull call spreads. For those unfamiliar with these combination plays, you would be long a lower strike call and short a higher cost one. As the name suggests, it's a strategy for times when you expect the underlying to rise.
McMillan comments that a rise in implied volatility harms the bull spread. Huh? Try as hard as you can and despite McMillan's helpful graphs, you can't wrap your mind around that concept. You need to put pencil to paper, or fingers to keyboard, and crunch the numbers. The CBOE website provides you with the tools needed to do that.
After its modest beginning April 26, 1973, trading 911 contracts on sixteen listed stocks, the Chicago Board Options Exchange had by 2000 traded 200 million contracts in a year. By then, the CBOE had added puts, not available until four years after that first day of trade. Along the way, the CBOE also adopted the Black-Scholes model for pricing options and introduced LEAPS, the VIX, the VXN and the CBOE-100 Index, since renamed the OEX, among other additions. It also created The Options Institute, dedicated to teaching investors about trading options, and developed a website. Your search for understanding McMillan's comment starts at the website (www.cboe.com) at the "Volatility Optimizer" tab under "Trading Tools."
You find a free service titled "IV Index." Clicking that link connects you to a tool supplied jointly by the CBOE and IVolatility. You decide to use the OEX for your number crunching. Plugging in the OEX's symbol, you locate tables on historical and implied volatility, volatility graphs, and the following chart, with only the call portion copied here. According to information on the site, the chart was at the close of the day February 2. It's updated daily.
OEX Call Options:
You note that the implied volatility does appear low, so it's at least easy to imagine that volatility might increase. That gives you extra impetus to discover what would have happened if you had instituted a bull call spread about February 2. The same page provides you with the information that just a week earlier, implied volatility for call options had been 10.37 percent and a month ago, it had been 13.27 percent. You decide that for the purposes of your calculations, you'll imagine that volatility has risen to 11 percent in a week's time.
You'll set up a paper-trade bull call spread using the February 565 as your long position and the February 570 as the sold position. You'll use the option value provided in the table shown above rather than searching for bid/ask quotes, available on another part of the site. This would not exactly mimic the costs of a spread you actually traded, of course, but simplifies your calculations and serves the purpose of testing McMillan's statement.
The chart provides you with a $7.60 cost to buy the Feb 05 565 call and a $4.30 credit to sell the February 570. On paper, you've established the bull call spread for a total debit of $3.30. Now you want to see what would happen if volatility expanded to 11 percent one week later. Imagine that the OEX had remained at that February 2 closing price of $570.28, ensuring that you're measuring how volatility affects the spread and not how a change in price does.
Also under "Free Services" on the "Volatility Optimizer," you'll find "Options Calculator." You input the new values, including the strike, 11 percent volatility, $570.28 price, and the new number of days (10) until expiration.
Clicking the "Calculate" button returns the following numbers.
The long 565 strike now shows a value of $7.57. Following the same procedure for the short 570 call returns a value of $4.49. As McMillan predicted, the spread has suffered. Your long 565 call is now under water by $0.03, and the sold 570 is now worth $0.19 more than you collected. You plug in a few more numbers and now have a hands-on feel for what McMillan meant, all courtesy of the CBOE website.
This information could have been obtained by visiting IVolatility's site, but the CBOE's offers more. Perhaps you've never traded index options. As you're making these calculations, you wonder what would happen if both options are in the money at expiration. Are you going to have to deliver somewhere upwards of $57,000 worth of S&P 100 stocks to a $570.00 call buyer?
You can always ask someone on the OptionInvestor staff. (Hint to new options traders: No, you wouldn't be delivering those stocks.) If it's midnight, you're less likely to find someone at OptionInvestor to answer your email, but the CBOE site has that answer for you, too. Under the "Learning Center" tab on the home page, you'll find "Ask the Institute." Your question has already been answered in the archived questions. If you hadn't located the needed answer there, you could have submitted your own question. The Institute chooses questions at random to be answered in the "This week's question" section.
The archived answer refers to index options as being cash settled. What does that mean? The "Options Dictionary," found under the same "Learning Center" tab, provides the answer. Perhaps all this research prods you into learning more about option expirations, settlement and assignment. You've come to the right source. In the same "Learning Center" section, you'll find a pull-down menu under "The Options Institute."
Under the "Online Tutorials" section, shown here in orange, you find a 15-minute course titled "Options, Expiration and Settlement." It's free. Under "Educational Webcasts," you can register for a twenty-minute course in the basics of trading index options. If you've advanced beyond those basics, perhaps advanced strategies are right for you. They're available, too. Somewhere in those courses, you'll find information that you wouldn't have wanted to create this imagined bull call spread in real-life unless you thought the OEX was headed higher. Due to your research, you would know that you perhaps wouldn't want to consider one in a low-volatility setting.
For-fee seminars and events are also available. By this time, you're deciding that the CBOE site has much to offer, but the surface hasn't been tapped yet. Click under "Products" and you'll find a tab that directs you to index sites. Want to know the components of the OEX since you're imagining that you created a spread on the OEX? Click through to the OEX's site.
You notice that MedImmune (MEDI) is an OEX component and you remember that it reported February 3. What was MEDI's outlook? Want to listen in on a recording of the earnings conference call? Back on the CBOE's home page, you'll find a tab for the Equity Research Center, and there's an easy link there to the conference call. You'll also find links for conference presentations. For example, if you wanted to listen to MedImmune's November 8, 2004 presentation at the CIBC World Markets 15th Annual Healthcare Conference, you'd find it in that same section.
This article was not meant to offer a comprehensive overview of the information and tools available at the CBOE site, but rather to encourage both new and experienced options traders to spend some time clicking through the various offerings. Some day when markets refuse to move and there's no trade to be taken, give yourself a self-directed tour.