Why do commodity call options cost more than put options? Why does equity market protection cost more than bullish exposure? In this podcast former market-maker Matt Cashman, now educational instructor at the OCC, explains key options concepts such as skew and volatility. Matt describes in detail several of the critical concepts known as the Greeks that will help investors get to grips with trading options.
Summary – Traders’ Insight Radio Ep. 23: Everything You Wanted to Know About Equity Options but Were Too Frightened to Ask.
The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.
Welcome to Traders’ Insight Radio podcasts, you’ll find us at tradersinsight.news. Today’s guest is Matt Cashman, who’s a principal for investor education at the Option Clearing Corporation. Welcome, Matt, how are you?
I’m doing really well today. Thanks for having me, I’m excited to talk about options.
You’re very welcome. Matt is a regular guest each month on our webinar channel where he helped teach investors all about options, what they are and how to use them. So, a huge welcome, thanks for joining me and thanks for being such a great partner with Interactive Brokers.
It’s been a massively volatile and extremely rough first half to the year so far for equities as an asset class, but Matt, explain to us if you can; What are the major differences between trading stocks, indexes and commodities from the perspective of the options market?
Yeah, that’s a really interesting question Andrew. I generally tend to group stocks and indexes together in their own kind of little bubble and then commodities on the other side in their own bubble and then obviously currencies are a little bit different, but from an options perspective stocks or equities and equity indexes are generally and — the big difference between them is really in the concept of skew as far as the options and how the options are priced.
And the reason why, here is because when you look at price history for equities and indexes, generally their price history shows that they crashed to the downside and they stair step or have more placid moves to the upside and so over time what that does from a distribution perspective mathematically, is it makes one side of the distribution more expensive than the other side of the distribution. Well, in stocks and indexes you can imagine the downside is going to be more expensive because that’s where the more violent moves happen, and so puts end up being a little bit more expensive than calls.
On the other side of that coin is that in commodities, commodities generally tend to crash up and they have what’s called demand skew, and so their big violent moves usually happen to the upside and not the downside. And so, on the commodity side of things you’ll get the opposite of the equity skew. You’ll get call skew where the calls are actually more expensive than the puts, and so when I think about those kind of asset classes and I had to actually kind of do that myself when I went from trading equities to commodities. I had to flip that skew in my mind and all of a sudden make the calls kind of theoretically more expensive mentally. And so that’s the big difference from my perspective as to when you talk about options and those asset classes specifically.
So well, while we’re on that on that topic, then do you want to drill down in a little bit more into option volatility skew? Why does that exist and how does it work?
Yeah, that’s skew is one of those concepts that people who are professional traders know intimately very well, but from someone who’s a more intermediate or a beginning trader, they don’t really understand the concept of skew necessarily because a lot of times they’re trying to just kind of wrap their heads around how the options work in generally right? And skew is one of those kind of second derivative concepts where you need to understand the basics in order to understand skew.
But skew is like I said, just the difference between one side of the distribution being more expensive than the other side of the distribution. Or for instance, if you had like a 20% out of the money put and a 20% out of the money call in the equity market theoretically, generally, the puts going to be more expensive by X percent, you know? And the reason why is what I just noted in my previous explanation, which is the price history kind of dictates that right?
The price history has shown that those puts are — If you take it, and you amortize it over a bazillion years, those puts are going to be more expensive and a better investment than the calls are, because they’re going to pay out more most of the time.
And then on the opposite side, you’ll get situations even in equities and indexes where calls can become more expensive. Don’t put yourself into a situation where you mentally have built this model where calls are always less expensive than puts. I’ve been in several situations where things get out of whack and the call skew gets so high that the calls are actually more expensive than the puts. It’s a very disorienting situation if you’re trading equity options because it’s not usually how it’s priced. But that’s how it works, and skew is really– aside from the basis of skew being based in price history and the mathematical kind of like evolution of that really skew is just a function of supply and demand, and how much people are willing to pay for both sides of that distribution whether calls are more expensive or puts are more expensive.
Very good, OK well we’re going to get into the various Greeks later and I’ll let you define volatility concepts later as well. But first, let’s talk about something that rarely gets discussed when talking options. Talk to me about the exercise and assignment process. First of all, can you explain that for listeners and then explain what the role of the OCC is in that process? Talk about some of the risks that end users and investors or traders should make themselves aware of regarding that part of the options lifecycle.
Yeah, absolutely this is something and I’m really glad you asked this question, Andrew because I and you may know this from a first-person perspective, but in every single one of my webinars, almost inevitably I mention exercise and assignment and the reason why is because from my perspective, it’s one of those parts of the options world that is really, really important as far as P&L is concerned. But it’s not very sexy and people don’t talk about it very often. They like to talk about how much they’re going to make and leverage, and all of those things. They never really think about or talk about exercise and assignment, but it plays a huge part in how these things work.
Now let’s talk about it from just the bare bones of how it actually works from like the financial rails that are behind the system, right? So, OCC is the largest clearing house of equity and index options in the United States and so if you’re trading index or equity options in the US, the OCC is touching that option somewhere along the line. Either in the exercise and assignment process, which we’ll talk about now, settlement, clearing all of those things behind the scenes, the OCC is somewhat involved with. Now when you are long an option, you maintain the right to exercise that option, and in the case of an American style option, you maintain that right to exercise that option at any point during its lifecycle.
American options and European options are different. Those are two different kinds of options. American style options are generally equity options in the US. You can exercise those anytime during its life cycle. European options slightly different, but the main difference is European style options, which are usually index options in US. European style options can only be exercised on their expiry date, so that’s the biggest difference there. Now, when you decide to exercise an option, if you’re long an option and you decide to exercise it this is how it works.
You press the button on your screen that says exercise basically. That exercise notice goes to your brokerage or your trading firm. Then it goes from there to the clearing member firm. The clearing member firm is the firm that has the direct relationship with OCC. It goes from that clearing member firm to the OCC where it gets aggregated and then OCC has a randomized and proprietary process by which we match up the buyers and the sellers, or the exercisers and the assignees in this case.
So, the person who exercises comes in and then we match it up through a randomized process. It gets assigned to someone who short that option. It goes out the door through the same rails that it came in with goes back out through the clearing member firm to the brokerage firm and then the brokerage firm has their own general assignment way that they figure out which one of their clients is getting assigned, is getting that assignment, but it comes in as an exercise notice, it gets matched and then it goes out the door as an assignment.
Here’s the risk that you maintain from the end user’s perspective and this is what you need to always understand. Each one of these brokerage houses actually manages their operational risk by having a cut off time that is standardized across their clients as to when they can exercise their options. Those clients can exercise up until that point in time, but that time can be different from brokerage house to brokerage house and from trading firm to trading firm. You need to understand when you are able to actually exercise your option because of your relationship with your specific brokerage firm, because the person sitting next door to you might have a different relationship and thus can exercise their option at a different time.
And so if your cut off time is 4:00 PM and their cut off time is 4:15 and the stock moves at 4:07, you’re not going to be able to exercise your option, and if they have the exact same option, they might be able to still. And so that’s your main risk, the last point in time that you want to be running around with your hair on fire trying to figure out when your exercise cut off time is two-minutes before that bell rings for you. Because trust me, I’ve been in that situation, and it doesn’t yield good results.
All right let’s dive into the Greeks. In your opinion, Matt, what are the most important option Greeks that people trading options should have on their radar?
That’s a really good question. Option Greeks are one of those things that it’s you can dive into in lots of different ways and learn kind of an infinite amount about over time and how they interact with each other. I’ll try to keep it as simple as possible for the purposes of this. The 1st order Greeks, there’s five of them: Delta, Gamma, Theta, Vega and Rho. Now Rho, we can kind of take off the board because it deals with interest rates and generally speaking, interest rates don’t move that much with short term options to make it, you know that– That’s not going to be the headline thing that I’m going to address.
I’ll say from my perspective if you’re dealing with an option that’s say less than 90 days in duration. If it’s a three month or less option, I think the number one thing you probably need to look at is gamma and gamma and how it affects your delta of that option because those short-term options are more sensitive to movement and that’s what gamma measures. And then if it’s a longer duration than 90 days, if it’s a three month and out option farther out, I’m going to say I think Vega is really what you should have on your radar as the number one thing because those options start to transition into what we call Vega rich options or like really Vol rich options and what that means is that they are very sensitive to movements and implied volatility and less sensitive to movement in the underlying like those 90 day or sooner options are. And so, an option that’s the duration is less than 90 days. I’m going to say Gamma is probably the most the most important that you need to look at post 90 days. I would say Vegas should be on your radar at the top of the list.
Very good. OK, here’s a question that did pop up in a recent webinar that I wanted to run back by you. Can you explain the differences between credit spreads and debit spreads and what are the risks and characteristics of each?
Yeah, absolutely. Credit spreads and debit spreads are pretty simple relatively speaking. Credit spreads if you are selling options or selling bigger options than you’re buying in your spread. For instance, if you’re selling a $7.00 option and buying a $5 option you have created essentially a credit spread. What that means is that you’re getting paid a certain amount of premium for the position that you’ve just put on. Generally speaking, credit spreads incur the liability of being short an option that is closer to at the money than the option you’re long. And that’s the reason honestly, why you’re getting paid in the 1st place, right?
Those options that are closer to at the money have a higher likelihood of becoming in the money options. Thus, they’re higher delta, they’re higher gamma, all of those things, and that’s the reason they’re priced more. Now from a risk perspective, the way you need to think about it is that you’re short the option that has a significantly higher percentage chance of becoming in the money, and so you need to build that into the way that you manage that position.
Now, conversely, debit spreads are the opposite of that. Debit spreads are you’re buying an option that is usually bigger than the option you’re selling, and what that usually means is that you’re buying the option that’s closer to at the money or has a higher likelihood of actually becoming in the money and thus becoming an exercisable option like we just talked about before. And so, for that right, you are actually maintaining that exercise right through the life of that option, but you have to pay for it. And so that’s where the debit comes from. You end up paying for that, right much like the other person who sells it to you actually, gets credited that amount of premium, but they incur the obligation to deliver or take delivery of the stock when you decide to inevitably exercise, or it expires worthless. So that’s the big difference between those two things and the. Big difference in risk.
OK, here’s another one that someone new to options really needs to know. Can you explain the difference between implied volatility and historical volatility?
Yes, that’s one of my favorite topics to talk about Andrew, you know this. I’ve done a couple of webinars just on this topic itself.
Implied volatility… The short answer is really simple. Implied volatility has to do with option valuation, and it’s a major component of how we price options and it’s a big part of how much options are worth. It controls a large part of how much of the value, the extrinsic value of an option is worth, because it’s one of the biggest components of that extrinsic value. Now, implied volatility is the market’s best forecast of what this underlying is going to kind of deliver over time. How volatile is the underlying going to be during the duration of this option?
Historical volatility is just that, it is history. It has already happened. It is what you can quantify. You can put it into a spreadsheet. You can do all kinds of things with that data set, but really all it is a measure through prices that have previously happened. It’s a very black and white thing. This is something we can all agree upon. It’s already happened. It’s set in stone. You can measure it and it is really just a measure of how much the stock or the underlying has moved over a previous historical period of time. That’s the big difference.
OK, but how does implied volatility work? What are some of the factors that move it around and where does that come from?
Implied volatility, like I said, is one of those inputs into an options valuation that move. It’s a really dynamic feature of how options are priced, and it moves all the time. Theoretically speaking, it’s really a function again of just supply and demand, just like what I talked about as far as skew earlier in the in the podcast. Skew is supply and demand. It’s a function of how much people are willing to pay for options or sell them at a certain price, and implied volatility is much the same way.
Any time that you buy or sell an option and it prints a certain price, that price itself when you take into account the rest of the metrics around it, so the strike price, the underlying price, the days to expiration. All of those things that build into the options price. It creates an actual implied volatility level. Every price has its own implied volatility level. And so, one option can trade many different implied volatility levels during the day, during one day, during one minute it can. So, the price of the option and the way its printing is what is actually determining what that implied volatility level is, and it’s really a function of supply and demand.
When you’re a market maker, when you’re a professional market maker, one of the only things that you can really move around in your model in order to affect change in how much an option is worth… If I want to take all the options in one month and move them up by X percent, the biggest dial I can turn is implied volatility. I just crank it one direction and then all of a sudden, all the options in that month are worth a lot more or a lot less. And so, then you start moving skew and other things around also, but the big like the big bat that you swing as a market maker when you’re modeling options is implied volatility, and that’s how they move.
Very good. Now just to ram home the importance of some of these concepts. Matt, if you had to choose just one thing to remind investors who trade options to pay attention to what. Would it be?
Wow, one thing, I’m going to make this a timely answer because the market is moving around as much as it is right now and particularly in markets when they’re when they’re relatively volatile, I think people need to pay attention very closely to open-ended risk. And what that means is when you are — Sometimes you have long options and short options in a portfolio, you’re long this option. You’re short this option, but if you’re not closed off as far as having a unit neutral position. Meaning I’m long one, but I’m short two and then I need to be long one option also somewhere else in order to be unit neutral. You need to pay attention to where your open-ended risk is. An open-ended risk means like you’re not long options past a certain point, you end up with, you know you just have unlimited risk to one side or the other.
Some people love to trade that way, and they’re really adept and very good at managing that risk in an options market such as this where things are moving around a lot. That should be on your headline as far as risk is concerned. Take a look at where your open-ended risk is. Make sure you’re managing your risk when it gets to unlimited levels like that when you’re just short options in one place. And make sure that’s something you want to have on, if that’s what you want to have on. Then by all means you should have it on, but you need to understand how that risk works when it’s open ended.
Matt, you began your career on the CBOE, in the open outcry exchange floor when it existed, and then you traded over in London on the Eurex as well. So, you’ve touched both sides of the Atlantic. You must have some great stories from those days. So, tell us your favorite trading story.
My favorite trading story. Well, I have a lot of stories like I told you before, many of them are not fit for public consumption because of where they come from. Trading floors are generally not the most politically correct environments, but I will give you one that is fit for public consumption. So, when I moved to London, and I started trading in London, it was after the LIFFE floor had closed and all of the trading was moving upstairs into an upstairs environment. And so, what we had was giant banks of trolley machines which were giant phone banks. And then we would take calls for option trades, and we would spread most of our risk on the screen and through other trades. But what that meant is that I had to figure out how to talk to people who were English all the time immediately, like overnight, and so I picked up a lot of obviously English slang and things like that.
Because it’s a different language altogether, right?
It is really, and you know this, Andrew. But and you might get a kick out of this honestly, the first two weeks I was there all of the English brokers on the phone referred to me as Seppo and I didn’t understand why and I didn’t know why, but they kept calling me Seppo. For those of you who are not initiated to Cockney rhyming slang that is a way that in some ways people refer to certain things without saying the actual word. They’ll use a word that rhymes with it in order to reference that word. So, for instance, we used to go get beers after work at the pub, but instead of calling them beers, we would call them Britneys. Well, why did you call him? Britneys ’cause Britney Spears, Spears rhymes with beers. So instead of, you’d say let’s go get some beers you’d say does anybody want to get some Britneys right?
And we’ll go up the apples and pears. We’ll walk up the stairs.
Yeah, there you go. Apples and pears. Pears rhymes with stairs, right? So, after two weeks I kind of started wondering why everyone was calling me Seppo. Well, one of the junior traders who was English on the desk found out that I was trying to figure it out. And he said, Cashman, don’t you understand why they call you Seppo and I said “No, I don’t. I don’t get it.” He said septic tank. Tank rhymes with yank. They’re calling you a Yankee. And I was like Oh no this whole time. It’s been two-weeks and I’ve been responding on the phone to Seppo like it was my name, and so I finally figured it out and we all had a good laugh at it. But they were all — All the English guys were like we were wondering how long it’s gonna take you mate to figure this out?
We was running a book on how long it was gonna take you, won’t we?
Yeah, exactly. Exactly, so that’s my favorite part.
Yeah, I heard exactly the same thing from a broker. We were in a famous London restaurant, and they were talking about septic. So, I was like “what’s he talking about?” Septic tank… yank you know mate?
You know mate, the Seppos. So yeah, my other favorite one is when I would call, I would always call for one broker that I wanted to talk to and his buddy would answer the phone and say, “No mate, Mac is not here he’s on the dog.” And I’d be like on the dog? Dog and bone, bone rhymes with phone. He’s on the phone. He’s on the dog mate. I have to call you back. I was like alright, but that took forever for me to figure out as well. He’s on the dog. What is he talking about? So that was always fun. That was England, yeah.
Brilliant, brilliant. Alright well thank you very much Matt.
And don’t forget folks to check out the IBKR campus online for all of your trading education needs. You’ll find plenty of course material at Traders Academy.Online, including an advanced options program from the OIC. You can find more options education from today’s guest, Matt Cashman at optionseducation.org. And any of his prior recordings at ibkrwebinars.com, just look under the contributor section and click on OCC. And finally, you can reach Matt directly by email using email@example.com. Thanks for joining us today. Thank you, Matt.
Thank you very much Andrew. It was a blast.
Alright, I’ll see you next month. Bye for now.
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