Category: Definitive Edition

The Biggest Debate in Europe: Brexit

The people of the United Kingdom have a perplexing decision to make on June 23. They must decide whether to stay in – or leave – the European Union. The upcoming vote, commonly referred to as “Brexit”, is expected to be a close one.

Above is a recent poll by Forex Capital Markets. The “remain” side wishes for Britain to stay in the European Union (EU), and the “leave” side wishes for Britain to exit. As we can see, the two sides are neck and neck in poll standings. With the popular opinion virtually split, let’s hear some arguments from each side:

Arguments to Leave the EU

Currently, the EU is burdening Britain with laws and regulations. These include excessive regulations on British businesses in areas like health, employment rights, etc. The EU also forces Britain to let in migrant workers from poorer European countries. These migrant workers then compete with British workers for jobs in unskilled labor. This drives down wages for the British working class. By leaving the EU, the UK can remove bureaucratic regulations, limit unnecessary immigration, and thus take back control of its economy. This is why people like Boris Johnson, Michael Gove, and Donald Trump support the “leave” side.

Arguments to Remain in the EU

Britain must remain and contribute to the EU- rather than abandon it- to protect its world status. According to the CIA World Factbook, the EU has an annual GDP second only to the United States (https://www.cia.gov/library/publications/the-world-factbook/fields/2195.html), making the union an economic powerhouse. If Britain were to leave the EU, then it would certainly have much less economic status than it does now.

Britain might also encounter a serious recession if it leaves the EU. Because of its enormous economic power, the EU is currently a major trading partner of Britain. If Britain leaves, it might see a significant reduction in trade, which could cause an economic downturn. Overall, staying in the European Union will be much better for Britain’s future. This is why people like David Cameron, Barack Obama, and Angela Merkel support the “remain” side.

Comparison to the Grexit Movement

The Brexit debate is quite similar to the Grexit controversy that occurred a year ago in Greece. Like Brexit supporters, campaigners for Grexit wanted increased control in their country’s borders. They wanted less of their laws made by the European Union and more of their laws made by their own governments. However, there is a key distinction between Brexit and Grexit. Greece was just considering leaving the Euro currency while Britain is considering leaving the European Union altogether. This is because Greece still needed the European Union to help revive its crumbling economy, while Britain may be able to survive on its own. Ultimately, the Grexit movement failed as Greece decided to remain a Euro currency member. As for the Brexit issue- we will have to wait until June 23 to find out.

– Ken Croker

Which side of the Brexit debate do you support? Leave a comment in the section below!

Hillary and Biotech

Biotech companies should be kept from setting drug prices too high…. right? After all, shouldn’t consumers be able to afford life-saving drugs? Hillary Clinton sure thinks so. Recently, Daraprim, a drug used to fight AIDS, was bought by Turing Pharmaceuticals. The price “skyrocketed” from $13.50 to $750. Take a look at this tweet by president-wannabe Hillary Clinton:

“Price gouging like this in the specialty drug market is outrageous. Tomorrow I’ll lay out a plan to take it on. -H”

This tweet sent shares of biotechnology companies like Biogen Inc. (BIIB) down almost 8.5% in the following week. Shares of the tracking ETF “CURE” for biotech were down nearly 25% in the same period.

Hillary Clinton sure has a point. However, she is misunderstanding fundamental tenets of the free market, or at least pretending to misunderstand these basic truths in order to appeal to her uninformed voting base. Consider the motives behind even producing a lifesaving drug for a minority. In the past few hundred years, only recently have these drugs emerged. Were they created by individuals seeking to help others? Well, that was definitely one possible motivation, but most drugs were produced by companies seeking profits. These companies realized that some individuals with rare diseases were not going to be served by the majority of companies, who in turn thought that since there only were a few consumers, they would not be able to offset the expenses from research and development. The solution? Charging high prices.

High prices are the only way for companies to turn a profit producing a drug for a rare disease. If the government sets a “price ceiling,” which sets a maximum price a drug can be sold at, companies will no longer have an incentive to research these drugs. In effect, the government would be killing the industry and even killing those who would have benefited from the drug.

The common flaw pointed out in this argument is that consumers will not be able to afford these medicines. However, almost all legal citizens of the United States have health-care insurance coverage. Insurance companies are more than willing to charge premiums to consumers who wish to have insurance in the case of catching a rare disease. In effect, all the consumer has to pay for is the insurance premium. With the advent of dubious measures like the Affordable Care Act, even these costs may be offset by other citizens who can afford.

What is the solution? It is simple: Allow the free market to work. Insurance companies are willing to pay high prices, and pharmaceutical companies should be able to charge whatever price they want. If their price is too high, insurance companies will not be willing to support the drug, and there will be no demand, and the price will be automatically lowered to increase revenue for the pharma company.  Supply and demand will work out the price, and government price ceilings can be shelved.

At the Finance Club, we are aware that Hillary Clinton is a very educated individual. However, we also understand that she has to appeal to voters who have not had the opportunity to consider these basic economic facts.

 

– Finance Club

Comments? Arguments? More than welcome! Reply to this post, and you may even get a response.

Futures Basics

Level: Intermediate

A futures contract is defined as an agreement to buy or sell an underlying at a later time, but today, futures have far more important uses and implications on the general market.

What is a Future?

Think of a future as a contract. Futures were initially created for the agricultural world. Farmers, who put time and money into their crops, did not want to see their profits evaporate just because of changing spot prices for the crop they were raising. Food manufacturers also wanted to lock in a stable price in order to ensure that they could purchase raw food at a reasonable price. The solution was an agreement between the two parties: Farmers agreed to sell to the manufacturer a product for a certain price. This contract is called a futures contract simply because it locks in a price of exchange for both the buyer and a seller regardless of the spot price at any future time.

Let’s consider a general example. A established a future contract with B to sell one unit of product to B for a price of X. Imagine that the price of the product increases to X + 10. The result would be a relative loss for A of 10, in terms of opportunity cost, and a gain for B of 10. On the other hand, if the spot price of the product had since depreciated, A would win by 10 and B would lose by 10. This is a conservative situation, analogous to conservative forces in physics. Money is conserved, and this is a zero sum game between the two parties.

Instead of taking actual delivery of the product, what would happen if the contract was cash settled? Take the same situation and the same futures contract. A few months after the contract is established, the product price is at X + 10. That would result in a loss for A, and a gain for B, as we have determined before. However, the contract has not reached maturity, and A wishes to nullify the contract before further losses are realized. A cannot legally nullify the contract under U.S. contract law without B’s consent. However, what A could do is negotiate with B in order to establish another contract. This contract would state that B would sell A one unit of product for X+10. Upon maturity, both A and B would swap product in order to realize A’s loss and B’s gain, both of which are dependent on the move since the second contract was established. The swapping of the product was unnecessary. Therefore, instead of physically trading product twice, why couldn’t A and B have simply settled the two contracts with cash? A would have to pay B the amount of 10, and there would be an equivalent and more efficient solution. This nullification retains the same initial property of a single contract: money is conserved. Therefore, we can expand this situation to involve more than one person.

Let’s use the same example, but also assume that B is unwilling to strike a second contract with A. Instead, a third party, C, is introduced. A establishes a contract with C that states that C would sell A one unit of product for X + 10. Consider what would happen at expiration if the final price of product was X + 5. A would lose 10, because he already nullified his positions previously. B would net a gain of 5. C would also net a gain of 5. Again, the conservative nature of the contractual exchanges is retained. Let’s extrapolate this situation to the general market. C could represent an entire network of buyers and sellers, with only a few parties actually using futures to hedge the actual product or take delivery of it. This is where the fundamental nature of the futures market comes around, and it explains why such a wide variety of futures products for trading exist, why traders trade them even though they are not interested in the underlying itself, and the inherent risk in trading such products.

Today, the futures market is extremely large, with $81 trillion outstanding in 2008. Compare this to the entire world’s stock market, at $55 trillion.

What is the Structure of a Future?

Look at the following link to see a list of traded commodities that futures exist on: http://en.wikipedia.org/wiki/List_of_traded_commodities. Futures are traded on more underlyings, too. For example, the E-mini S&P futures have an underlying of the S&P 500 index. The index cannot be traded, or exchanged, or delivered, so the resulting bets are settled in cash. This again points to the speculative nature of futures and exemplifies how few people actually wish to own the underlying.

Trading hours: These vary depending on the underlying. A full list for CME-traded products is here: http://www.cmegroup.com/trading_hours/. The E-mini’s hours are: MON – FRI: 5:00 p.m. previous day – 4:15 p.m.; trading halt from 3:15 p.m. – 3:30 p.m. As you can see, hours differ significantly from the stock market.

Tick size: This is the increment in which contracts are traded. The E-minis trade in increments of 0.25. Additionally, there is a multiplier for each contract traded, just like with options, that varies. The E-mini multiplier is 50, which means the actual dollar value is $12.50 for each increment.

Exchanges: These exchanges are some of the more popular ones: Chicago Board of Trade (CBOT), CBOE Futures Exchange (CFE), Chicago Mercantile Exchange (CME), Commodity Exchange (COMEX),  Globex (GBLX), Intercontinental Exchange (ICE), Kansas City Board of Trade (KCBT), Minneapolis Grain Exchange (MGEX), and the New York Mercantile Exchange (NYMEX).

Futures are issued for different underlyings with different expirations. The one you will see listed is the nearest expiration, or the “active” one. Volume is usually highest for these contracts also. Different naming conventions for expirations can be seen at Wikipedia.

Why Do Futures Matter?

Traders who trade futures with no interest in owning the underlying still affect the underlying spot price. This concept is best illustrated with an example. The Flash Crash that occurred in 2010 that caused the Dow to drop almost 1,000 points was triggered by an event in the futures market. An institution sent a large sell order for the E-mini futures that couldn’t be filled. This triggered a major selloff in the futures market. High frequency trading algorithms then extrapolated that fall in futures, noticed a tradeable arbitrage opportunity between the E-minis and the Dow and S&P and other large corporations, and took the opportunity. This in turn caused a large selloff in the equities market as a whole.

If an individual investor like you wants to trade futures, you must obtain Tier 2 approval from your brokerage account, and maintain sufficient margin to carry out any trades. Options on futures require Tier 3 certification.

Conclusion

Futures are an important factor to consider in today’s market environment. Their history is intertwined with the speculative nature of such contracts, and explains why futures gyrations can have an effect on the market. When trading futures, keep in mind that they are instruments that are as speculative as options.

Questions

Completion of the following questions is mandatory for club officers and future officers, and is recommended practice for everyone.

  1. Research the Flash Crash, and write three or four sentences on why HFT systems would take advantage of a fall in futures prices.
  2. Research the history of futures, and write three or four sentences in which you explain the beginnings of the futures market (include where, when, and why).
  3. Create your own scenario in which a Flash Crash occurs. Do not use the same scenario as the original one, as those failures have been corrected by safeguards. Be realistic and thoughtful while thoroughly explaining the nature of events and the sequence that leads to a large fall in the S&P 500 and/or Dow. This will be 5-10 sentences.

Volatility Skew

Level: Intermediate

Introduction

Volatility Skew is a broad term that refers to the distribution of implied volatilities (IV) across strike prices for a single expiration. It could also refer to an IV-Expiry graph, but we will be focusing on the more common definition. For a two-dimensional graph, the values plotted for a skew would be the strike price on the x-axis, and the implied volatility of that strike on the y-axis.

Keep in mind, though, that in financial lingo, volatility skew and volatility smile are two separate terms, both of which describe the shape of the graph.

Volatility skew graphs are commonly available in most trading platforms.. However, to graph multiple expirations, you would need a volatility surface, which graphs expiration on the z-axis. These charts are not commonly available, but you can view an example below.

Volatility Surface Example
Volatility Surface Example

Volatility Smile

A volatility smile is a pattern in which the Strike-IV graph looks like the following:

Volatility smile - Looks like a U
Volatility Smile – Looks like a U

This means that the ATM call is priced lower than the OTM options, both calls and puts. The actual price, of course, would be larger or smaller depending on the type, but the relative price difference is calculated from the discrepancy from a number given from an options pricing model (ex. Black-Scholes).

The discrepancy could be caused by a variety of factors, which depend on the type of security being analyzed. For example, a smile would represent fear of either a move to the upside or to the downside because it shows that people are willing to pay more than expected for the options, which are often used as insurance.

Volatility smile is more common in options with close expiries in the stock market or in the foreign exchange market in general.

Volatility Skew

Volatility skew is a situation in which strikes for only one side of strike prices have a higher implied volatility.

Reverse Skew - Looks like \_,
Reverse Skew – Looks like \_,

 

Some people call the reverse skew a “smirk,” and there are other names for different graphs. When someone refers to “skew,” they are most probably referring to reverse skew.

Reverse skew is also the most common scenario for longer-dated expiries in the equity market. This is because lower strike puts are purchased to shield against market drops. However, in other markets, like the futures market, a forward skew might exist to protect against a price spike (ex. utilities).

Evolution of the IV Surface

So far, we have been looking at what the numbers themselves actually represent. Let’s take a look at the derivative of these graphs, otherwise known as the evolution.

“Sticky strikes” is a term to represent a situation where if the spot price changes, the IV surface is unaffected for a certain strike. This is also called stick-to-strike or sticky-by-strike.

“Sticky moneyness” or sticky delta or just moneyness is a situation where if the spot price changes, the IV surface is unaffected for a certain delta. Delta is simply the variation in an options price relative to the stock price.

Modeling Methods

There are two ways that the IV can be modeled in the case of a volatility smile.

  • Stochastic Volatility – Quite advanced, but it simply uses a random Brownian motion process to influence a stochastic model, which cannot be exactly predicted, but can be analyzed.
  • Local Volatility – Simply the general definition of IV, where it is the function of an options-pricing model.

Conclusion

The volatility skew is a tool that lets one see how investors are pricing options, not just in raw dollar terms, but compared to the Black-Scholes model. There are many terms to represent the shape of the curve, and the change in the IV Surface has its own terminology.

How the VIX is Calculated

Level: Advanced

Overview

The VIX (Volatility Index) is a benchmark of implied volatility for thirty days in the future. It was created by the Chicago Board Options Exchange, or CBOE, in 1993. This article will focus on what the VIX is, how it is calculated, and how it can be applied. This is a concise version of CBOE’s white paper report for the VIX, which is quite a long and mathematical read.

What is the VIX?

The VIX is a measure of implied volatility in the market. Implied volatility is simply the expectation for how much an underlying asset will move within one standard deviation.

The VIX originally was calculated based on the S&P 100 index at-the-money calls. However, it was revised a decade after it was introduced so that it was based on a wide range of strike prices for options on the S&P 500. We will be focusing on the newer calculation method.

VIX Formula

This is the formula for calculating the VIX:

  • σ is the VIX/100. That means that the VIX is σ * 100. Notice that the formula gives you the square of σ.
  • T is how much time there is until options expiration. More on this below.
  • ∑ means summation (addition many times, don’t be scared). The i underneath means that i is a variable within the summation.
  • F is the forward index level. This is basically what people are predicting the S&P 500 index will be at in the future, based on options prices.
  • Ko is the first strike below the forward index level.
  • Ki is also a strike price, but of the ith out-of-the-money option. Remember the summation? For each value of i, Ki will change too. Ki is the strike of a call option if Ki is greater than Ko, a put option if Ki is less than Ko, and if they are equal it is the strike of both the put and call.
  • ∆Ki is just the interval or difference between strike prices around Ki.
  • R is the risk-free interest rate until expiration. This is not determined by options but rather by bonds. This is for the U.S. Treasury Bill maturing closest to the options contract.
  • Q(Ki) is the quote or the price of the Ki option. It is the average of the bid and the ask.

That’s all! The raw equation is quite simple, but some of the values used in the calculation require more in-depth analysis.

Keep in mind that the VIX measure expectations for 30 days, or a month, in the future. The time to expiration is calculated as follows:

T = {M_(Current day) + M_(Settlement day) + M_(Other days)} / Minutes in a year

  • M_(Current day) is how many minutes are left until midnight today.
  • M_(Settlement day) is how many minutes are from midnight on the settlement day to 8:30 AM for standard options, and till 3 PM for weekly options.
  • M_(Other days) is how many minutes are in the days between today and expiration

As we can see, T is just a fraction of the year representing how long it is until settlement of a contract.

VIX Calculation Process

This information is a simplified version of CBOE’s white paper on VIX calculation. The steps CBOE uses to calculate the VIX figure are outlined here:

  1. Select the options to be used in the VIX calculation. For EACH month:
    1. Take the the strike price at which the difference between prices for calls and puts is the smallest (price is the average of bid and ask). Do this for both the near term (or current term) expiration and the next term expiration.
    2. F = Strike Price from above + e^(RT) x (Call Price – Put Price). Recall that this is the forward index level, or F. You will get F1 for the near term and F2 for the next term options.
    3. Take Ko as the strike price below F. You will get two of these for each value of F: one for the near term, one for the next.
    4. Start iterating through the put options with strike prices less than Ko, and go down from there. Skip ones with bid prices of zero. If two consecutive strikes have bids of zero, stop. Select all of the options iterated through here for use later.
    5. Start iterating through the call options with strike prices greater than Ko, and go up from there. Skip ones with bid prices of zero. If two consecutive strikes have bids of zero, stop. Select all of the options iterated through here for use later.
    6. Select both the call and put with strike Ko. This will be treated as a single contract in the formula, with the prices for the call and put averaged.
  2. Calculate volatility or the σ values using the above formula for both near-term and next-term options (these are the contracts and values calculated in the outer step 1). The weighting of any contract to the VIX value is proportional to ΔK (the difference between strikes) and the price of the option. It is inversely proportional (negatively affected by) to the square of the option’s strike price.
  3. Calculate the 30-day weighted average of σ1 squared and σ2 squared. Square root that value and multiply it by 100 to get the VIX (look back at the VIX Formula section).

How the VIX is Used

The VIX itself is just a number used to gauge the amount of “fear” in the market. The nature of the VIX’s usefulness arises from the formula above, and is essentially provided by looking at how much people are paying for options (protection) from a market move. In terms of raw values, values above 32 are times of fear, and options pricing is generally more conducive toward premium sellers. On the other hand, values below 16 reflect a calmer market in which premium buyers get a better deal.

Over the years, the VIX has evolved from being just a number. Futures on the VIX index itself trade also, and multiple ETFs are plays on where the VIX will move.

Summary

The VIX is a powerful tool that uses a simple formula to calculate the amount of “fear” in the market. Although the raw calculation process is a bit dreary, understanding it will allow you to realize from where the VIX derives its meaningfulness. Of course, computers now track the index and its value is widely accessible on the web. Hopefully, this article has provided you insight on the inner workings of the CBOE Volatility Index.