Volatility Handbook Final

EQUITY DERIVATIVES
GLOBAL
Volatility Handbook
An Explanation of Basic Concepts, Strategies for Hedging and
Enhancing Portfolio Return, and Compilation of Selected Prior
Volatility Research
James J. Hosker
1.212.526.7460
jjhosker@lehman.com
Amit Dholakia
1.212.526.0885
amit.dholokia@lehman.com
February 2002
http://www.lehman.com
I. Introduction to Volatility
II. Volatility Concepts and Terminology
III. Trading Volatility
IV. Derivatives Trading Regulation and Market Structure
Volatility Handbook
Derivatives: The Key to Risk Management

There comes a point when a market observer begins to see beyond buy and sell, long
and short, black and white and perceives a more refined picture of the equity universe.
Degrees of bullishness and bearishness appear, and the observer wishes to align these
views with appropriately corresponding strategies. The risk of owning a stock outright
might seem too great or the leverage not enough. It is at this point that the observer can
make use of derivative instruments.
This guide is intended to be one building block in an education on derivatives. It is
meant as an introduction and a reference.
providing a working understanding.
Topics are discussed with the goal of
Readers are encouraged to access the Lehman
Brothers catalog of research to gain a more thorough understanding of individual topics.

A derivative is a financial instrument whose value is determined by an underlying asset or
benchmark. Assets and benchmarks range from corn crops, to the S&P 500, to the
Florida hurricane season. In short, derivatives can be tied to just about anything that
produces measurable results. This report is primarily concerned with equity and equitybased index derivatives, although the concepts are directly applicable to all types of
derivatives.
Originally, the term derivative applied only to transactions based upon an underlying
asset in which no money changed hands at the initiation of the contract. Forwards,
futures and swaps are examples of such instruments. Over time, the term derivative has
become associated with such products as options and exchange-traded funds and such
techniques as program trading. The common link between all of these concepts is that
they are a means of customizing risk exposure to match a view of the underlying. It is
this dynamic ability that makes derivatives extremely relevant in fashioning customized
payoffs and in controlling investment risk.
Understanding volatility is basic to an understanding of derivative securities. In this
handbook, we describe and develop the concept of volatility, discuss option strategies to
implement specific market views, and allude to pertinent derivative trading regulation and
market conventions that govern option trading. Finally, we provide a selected list of our
prior introductory research in this area.
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Volatility Handbook
Table of Contents
Derivatives: The Key to Risk Management ......................................................
................................ ...................... 2
Definitions
Defi nitions of Volatility ................................................................
................................ ...............................................
................................ ............... 6
Historical Volatility ........................................................................................... 6
Implied Volatility .............................................................................................. 6
Option Premiums: Paying for Potential ................................................................. 7
Single Stock and Equity Index Derivatives:
Derivatives: Futures and Options ........................... 8
Description of Equity Index Futures...................................................................... 8
Description of Equity Options ............................................................................ 9
Factors Affecting Option Pricing ....................................................................... 10
Comparison of Futures and Options ................................................................. 11
Interpreting Implied Volatility ................................................................
................................ .....................................
................................ ..... 14
Term Structure of Implied Volatility .................................................................... 14
Strike Structure (or Skew) of Implied Volatility...................................................... 15
Real-Time Implied Volatility Market Indicators...................................................... 19
Volatility Cones ............................................................................................. 21
Option Strategies to Trade Volatility ............................................................
................................ ............................ 24
New Developments in Equity Derivatives: The Excha
Exchange
nge Traded Fund (ETF) .......... 28
Investment Strategies Using Exchange-Traded Funds ............................................ 28
Conclusion ................................................................................................... 35
List of Available ETFs on Selected Indices.......................................................... 36
CostCost -Effective Trading: A Look at NasdaqNasdaq-100 Derivative Products ..................... 39
Market and Exchange Details ................................................................
................................ ....................................
................................ .... 44
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Volatility Handbook
Section 1: Introduction to Volatility
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Definitions of Volatility
Historical Volatility
In statistical terms, volatility is defined as the standard deviation of expected returns. It
reflects the degree to which an assets value changes relative to its mean over a given
number of observations.
Finally, volatility measures the degree of variability, not the
direction of the change.

In the case of securities, volatility measures the degree of price fluctuation over a specific
period of time.
Historical or realized volatility is a backward-looking measure that
attempts to quantify an assets price fluctuation over a given time frame in the past.
Realized volatility is calculated according to the following formula:
n
Realized Volatility =
(X
- M )2
i =1
n -1
where: Xi = observation
M = sample mean
n = number of observations
Realized volatility aims to analyze historical price fluctuation to anticipate future
performance.
Implied Volatility
Implied volatility is a forward-looking measure of the expected volatility level that is
implicit in option prices. An option-pricing model, such as the Black-Scholes model, can
determine a theoretical price for an option using other parameters to characterize the
underlying asset. The calculated price can be used to determine a theoretical level of
option implied volatility.
Volatility has value. An option on a highly volatile underlying security will tend to have a
high implied volatility as well. High volatility in the underlying asset is desirable to an
option buyer, because the option has a greater likelihood of expiring in-the-money, but
the buyer will have to pay for this volatility in the form of a higher premium. Conversely,
the rich premium associated with options on a volatile asset may be desirable to an
option seller who looks to absorb the premium by selling the option, thereby trading on a
view that volatility will eventually decrease.
While historical volatility is calculated based on an assets prior price fluctuations,
implied volatility, which gauges the markets perception of a contracts volatility, attempts
to quantify a range for an assets future volatility. Examining the sensitivity of implied
volatility to changes in option expiration and strike price provide valuable insights for
structuring an option strategy. Term structure, or implied volatility examined over short- to
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Volatility Handbook
long-term expirations, reveals the option markets expectations for volatility going
forward. As mentioned above, a highly volatile underlying asset has a greater
Term and Strike Structure of
Implied Volatility
probability of reaching far in-the-money and out-of-the-money (OTM) strikes before

expiration, because its price tends to fluctuate in a very wide range. Strike structure
reflects the option markets assessed probability that different option strike levels will be
reached by an underlying asset before expiration. Underlying asset volatility is a key
component in determining strike structure, as highly volatile underlying assets are more
likely to reach far in-the-money and out-of-the-money strikes. We explore term and strike
structure in greater detail in Section 2.
Option Premiums: Paying for Potential
Option premiums have two separate components: intrinsic value and time value.
Intrinsic value is the amount of profit that can be collected by buying an option and
exercising it immediately. For a call option, this is the amount by which the price of the
underlying asset currently exceeds the option strike price. If a call options underlying
asset value exceeds its strike price, the call is said to be in-the-money (ITM). If the call
strike is currently greater than the price of the underlying, then the call option has no
intrinsic value and is an (OTM) option. Conversely, put options, which give the holder
the right to sell the underlying asset at the strike price, are in-the-money when the option
strike exceeds the current underlying asset price.
Although an option may not currently have intrinsic value, which is true of all out-of-the
money options by definition, the option is still has time value as it is valid until the
expiration date, by which time the underlying asset value may have changed to a level
that makes option exercise profitable. It is in the time value component of the option
premium that implied volatility plays its role.
For equity calls and puts, further out-of-the-money options tend to have higher implied
volatility compared to near-the-money strike options. The further an option is out-of-themoney, the more exclusively its price is based upon volatility. This makes sense when
thought of in terms of the underlying asset. If Call ABC on stock XYZ is $15 out-of-themoney, what is it worth? To determine an accurate option premium, we first need to
answer another question: what is the likelihood that the call will ever be in-the-money? If
the price of the underlying stock is extremely volatile, then the chance of the call being inthe-money will be greater.
Implied volatility will reflect this probability, and the call
premium will be higher than it would have been if the underlying stock were less volatile.
We use the following conventions to refer to option strike prices throughout this document: ATM = at-themoney, ITM = in-the-money, OTM = out-of-the-money
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Volatility Handbook
Single Stock and Equity Index Derivatives: Futures and Options

Description of Equity Index Futures
Futures and options are two basic examples of derivative products, financial instruments
whose value is dependent upon an underlying variable that is often a traded asset, such
as a stock or an equity index. Futures contracts are normally traded on an exchange,
which allows for standardization in contract specifics such as size, expiration and
delivery method. Within the equity market, futures are generally available on indices and
2
some exchange-traded funds (ETFs), but are not commonly offered for individual
Futures Roll or Calendar Spread
equities. Liquidity in futures contracts is generally

generally concentrated in the nearestnearest-term
month (the closest expiration from the present),
present) which causes investors wishing to
maintain their current futures position to roll it forward to the next expiration. As
expiration approaches and futures roll activity picks up, the spread between the nearestterm contract and the next closest expiration, known as the calendar spread,
spread becomes
an important profit-and-loss consideration. We provide the formula for calculating the
price of a futures contract on an equity index, and illustrate its use as a hedging vehicle.
Equity Index Futures Price Calculation
(r q) * T
F0 = S0 * e(r q) * T
where
F0: futures price

S0: current index level
r: continuously compounded risk-free rate
q: annual index dividend yield. Since indices contain many stocks that usually
provide dividends at different times, we make the simplifying assumption that
the index can be treated as an asset with a continuous dividend yield.
T : time to expiration
Equity index futures are particularly effective tools to hedge risk in diversified portfolios.
Assuming that the maturity of the futures contract is the same as the duration of the
required hedge, the optimal amount of futures contracts needed to hedge depends on
three criteria: the dollar amount of the portfolio, the portfolio beta relative to the market
and the dollar amount of assets that underlies each futures contract. Generally, a portfolio
with a higher beta will require more futures contracts to hedge.
2
3
A complete introduction to ETFs is available in Section 3.2.
As defined in: Hull, John C., Options, Futures and Other Derivatives, 4th Edition, 2000. Prentice-Hall
Inc.
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Volatility Handbook
Calculating Number of Futures Contracts for Hedge

Hedge
# of contracts needed = b * PDV/AV

where: b: portfolio beta relative to market
PDV:
PDV portfolio dollar value
AV:
AV asset value underlying each futures contract
As the formula shows, the number of futures contracts required to hedge increases
with portfolio
portfolio volatility (i.e., beta) even if the dollar value of the portfolio does not
change.
Our comprehensive Handbook of World Equity Index Futures in Section 3 of this
publication provides a list of available index future, trading regulations, contract
specifications and exchange information.
Description of Equity Options
Equity options, derivative instruments offered on individual stocks, baskets of stocks,

indices and ETFs, are commonly traded on exchanges and in the more unofficial overthe-counter (OTC) market. At the most basic level, there are two types of options
options:
n Call Option: Gives the holder the right to buy the underlying asset by a certain
expiration date for a certain strike price.

n Put Option: Gives the holder the right to sell the underlying asset by a certain
expiration date for a certain strike price.

ExchangeExchange-traded options have standardized expiration dates and strike prices, but
customized options can be created and traded in the OTC market. European options
can be exercised only on the expiration date, whereas the more flexible American
options can be exercised at any time up to expiration. Depending on the underlying
asset, exercised options can be settled through delivery of cash or an equivalent amount
of the asset itself (called physical settlement).
4
As defined in: Hull, John C., Options, Futures and Other Derivatives, 4th Edition, 2000. Prentice-Hall
Inc.
5
IBID
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Volatility Handbook
Factors Affecting Option Pricing

There are five parameters (or variables) that affect the price of an option. Option
sensitivity to each parameter is measured by taking the partial derivative of the underlying
assets return function with respect to that particular variable. Each option parameter is
conventionally represented through a Greek letter and summarized in Figure 1.
Figure 1: Parameters Affecting Option Pricing

Delta (D
(D)
Change in option price resulting from an incremental change in the price of the
underlying asset. An options delta is a function of the underlying asset price and the
option strike price
price. Delta is positive for long call options and negative for long put
options.
Gamma (G
(G)
Change in option price resulting from an incremental change in Delta. Measures the
sensitivity (or convexity) of delta relative to the change in the underlying asset
price. The value of Gamma is higher for at-the-money, short-dated options.
Theta (Q
(Q)
Change in option price with respect to time remaining

remaining till expiration. Theta
increases as time to expiration decreases. One day before expiration, the value of
Theta is equal to the value of the underlying asset at that time. At expiration itself, the
value of Theta is zero.
Vega (V)
Change in option price with respect to volatility of the underlying asset value.
Vega increases as time to expiration increases and is higher for at-the-money strikes.
Rho (R
( R)
Change in option price resulting from an incremental change in the riskrisk- free
financing rate. Rho is positive for long call options and negative for long put options.
Source: Options, Futures and Other Derivatives 4th Edition by John C. Hull
Within the equity universe, dividends paid out by an underlying stock or index, which
lower the asset price on the ex-dividend date, have a negative effect on the value of call
options and a positive effect on the value of put options. The following table summarizes
the effects of each parameter on the option price (or option premium).
Figure 2: How Option Prices are Affected by an Increase in Parameter Value

Increase in
European Call
European Put
American Call
American Put
Strike Price
Time to Expiration
Underlying Asset
Volatility
+
+
+
+
+
Risk-free Financing
Rate
Underlying Asset
Price
Dividends
th
Source: Options, Futures and Other Derivatives 4 Edition by John C. Hull
In most cases, increasing the time to expiration will increase the premium of European
calls and puts, due to higher time value, but the dividend payment, which can lower the
stock price, makes the overall effect ambiguous. The early exercise feature of American
options makes the possibility of dividend payment immaterial, as the holder would simply
exercise prior to the scheduled payment date.
10
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Volatility Handbook
Comparison of Futures and Options

Futures and options are similar in their derivative nature, availability of standardized
contract conventions, and sensitivity to time. There is one important difference between
the two: A futures contract is binding with respect to the underlying asset, whereas an
option contract is not. An investor may enter into a futures contract without cost,
cost but
he is bound to buy or sell the underlying asset at the contracted price within the
specified delivery period
period. Conversely, options
opt ions give the holder the right to buy or sell
an underlying asset, but the holder can choose whether or not to exercise that right,
or let the option expire. There is a cost to acquiring an option, which is known as
the option premium paid by the buyer. Finally, we compare the payoffs from long and
short positions in equity futures and options positions in Figure 3.
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Volatility Handbook
Figure 3: Payoffs from Equity Futures and Equity Options Contracts

Futures have linear payoffs where a
long position has unlimited upside
and a short position has unlimited
downside.
Short Future Position Payoff
Long Future Position Payoff
A ssetP rice at
M aturity
A ssetP rice at
M aturity
D eliveryP rice
D elivery P rice
Long option positions offer the

upside benefit of futures with much
lower risk. The downside risk of
buying an option is limited to the
premium paid. Conversely, shorting
a call option (without a position in
the underlying) can cause unlimited
risk, which is mitigated slightly by
the premium collected from the sale.
Shorting a put option also provides
a premium and has limited risk to
the point where the underlying asset
loses all value.
Long Call Option Position Payoff
Short Call Option Position Payoff
O ption P rem ium

C ollected
O ption
P rem ium P aid
Strike P rice
P lus P rem ium
Long Put Option Position Payoff
Strike P rice
P lus P rem ium
Short Put Option Position Payoff
O ption P rem ium

C ollected
O ption
P rem ium P aid
Strike P rice
M inus P rem ium
Strike P rice
M inus P rem ium
Source: Lehman Brothers
It is evident that options offer investors more flexible ways to limit downside risk while
maintaining upside profit potential. In Section 3, we discuss the benefits of options
strategies that use combinations of calls and puts to translate market and volatility views
into trading positions.
12
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Volatility Handbook
Section 2: Volatility Concepts and Terminology
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Volatility Handbook
Interpreting Implied Volatility

Two important characteristics of implied volatility are its variation patterns over time,
called term structure,
structure). In this section, we
structure and across strike prices (strike structure)
Implied volatility measures market
perceptions of volatility.
provide comprehensive definitions of both concepts, and illustrate their significance to

option pricing and strategy. It is important to remember that term and strike structure
involve the implied volatility measure, which means that both gauge market perception of
future volatility levels across time and strike, respectively.
Term Structure of Implied Volatility
Term structure characterizes option value over time and helps determine the ideal
time horizon over which a strategy may be executed. Conventionally, the term
structure is charted from the nearest month expiration, which provides the clearest
Importance of the near-term

contract.
indication of the markets volatility expectations. Figure 4 shows the daily implied
volatility of 3-month, 6-month and 1-year option contracts on the S&P 500 in 2001. The
3-month contract in Figure 4 shows the greatest variability, while the 1-year contract is
the least variable, suggesting the tendency of implied volatility to revert to its mean value
over the long term. Intuitively, long-term mean reversion is an appropriate characteristic of
implied volatility. Implied volatility forecasts become less accurate as the time frame for
the forecast increases. While even short-term volatility forecasts cannot account for all
possible driving factors, uncertainty is large enough to eliminate any forecasting
accuracy for longer-term implied volatility. Conventionally, the best possible estimate for
longer-term implied volatility is its average value over time.
Figure 4: S&P 500 Implied Volatility Term Structure in 2001

Shorter-term contracts are
also the most variable. As
volatility is measured over
longer terms, it tends to revert
to its mean value.
3-mth
6-mth
1-yr
30.0%
27.5%
25.0%
22.5%
20.0%
17.5%
Source: Lehman Brothers, Bloomberg
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9/
2/
01
10
/2
/0
1
11
/2
/0
1
12
/2
/0
1
8/
2/
01
7/
2/
01
6/
2/
01
5/
2/
01
4/
2/
01
3/
2/
01
2/
2/
01
1/
2/
01
15.0%
Volatility Handbook
The following graph shows the term structure of S&P 500 implied volatility over the short
and long terms. We examine only atat -thethe- money (ATM) strikes, keeping the option
delta at each strike level constant to isolate the effects of term structure.
Mathematically, term structure differentials measure the slope at any point along the term
Term structure differentials
measure the slope at any
point along the curve.
structure curve, and can indicate changes in the option markets expectations for volatility
over the long and short term. For example, if the market begins to expect increased
volatility in the S&P 500 in the near term, the implied volatility of 1-month and 3-month
contracts will rise relative to longer-term contracts. If expectations are that volatility will not
Term structure reveals the

option markets expectations
for future volatility over time.
rise beyond a few months, the term structure might be flatter for longer-dated contracts.
Expectations of higher near-term implied volatility will cause the term structure differential
between 1-year and 3-month implied volatility (shown in the lower table in Figure 5) to
decrease.
Figure 5: Term Structure of At-the-Money Implied Volatility of the S&P 500
35%
Term Structure of ATM Impl Vol

3-Mth - 1-Mth Term Slope of Impl Vol
30%
Current
Avg
SD
SD Units
Postive/Negative Slope
25%
0.7%
1.1%
2.0%
-0.18
Normal
Current
Avg
SD
SD Units
Postive/Negative Slope
-0.2%
1.4%
1.7%
-0.97
Fairly Negative
20%
15%
10%
1-Mth 2-Mth 3-Mth 4-Mth 6-Mth 9-Mth
1-Yr
2-Yr
1-Yr - 3-Mth Term Slope of Impl Vol
3-Yr
Current
19.5% 19.9% 20.2% 19.9% 19.9% 19.9% 20.0% 20.7% 21.3%
One Week Ago
21.3% 18.3% 19.1% 19.2% 19.4% 19.7% 19.9% 20.9% 21.7%
One Month Ago 16.4% 20.2% 20.4% 20.6% 21.0% 20.9% 21.1% 21.5% 22.2%
3-Yr Avg +2 SD 27.6% 26.9% 26.9% 27.1% 27.3% 27.9% 28.5% 29.5% 30.1%
3-Yr Avg -2 SD
14.8% 16.9% 17.6% 17.9% 18.3% 18.5% 18.6% 19.3% 20.1%
Strike Structure (or Skew) of Implied Volatility

The strike price of an option affects its sensitivity to price changes in the underlying asset,
a relationship characterized by the option parameter Delta. The option premium
associated with a certain strike price is a function of the implied volatility of the
underlying asset. As mentioned earlier, volatility is the only option parameter not
observed or calculated, but is instead implied by the theoretical market price of the
option, which is derived through a theoretical pricing model such as the Black-Scholes
Model.
Each market-maker, however, has a different perception of future volatility,
which results in various levels of implied volatility that is observable in the market for any
given option contract. The divergence in implied volatility levels allows us to reasonably
Graph shows a snapshot of term structure as of Feb 5, 2002. For a daily update of global index term
structure, contact your Lehman Brothers sales representative.
February 2002
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Volatility Handbook
infer that the options market, while relying on some theoretical pricing model as a starting
point, does not consider that model to be completely efficient.
Strike structure of single stock
options.
The general shape of implied volatility skew, often called a volatility smile, indicates the
markets belief that large movements in stock price occur with more regularity than a
theoretical pricing model would predict, making OTM options more valuable.
Consequently, implied volatility of some single stock options that follow this pattern is
lowest for the ATM strikes, and increases as strikes are set further out-of-the-money on
both the call and put side, since large price movements are also almost equally likely in
8
either direction. Figure 6 shows the generic strike structure of implied volatility, which
has an equal likelihood of large price movements in either direction.
For single stocks, implied
volatility increases for further
OTM strike prices. The
volatility smile shape shows
that option markets believe
large stock movements are
likely events, which makes
OTM options valuable, and
that price movements are
almost equally likely to occur
in either direction (strike
structure is similar for single
stock call and put options).
Figure 6: Strike Structure of Implied Volatility for Single Stocks (Volatility Smile)
ATM Strike
Implied Volatility
Implied volatility increases

for OTM puts
Implied volatility increases

for OTM calls
7
8
Natenberg, Sheldon, Option Volatility and Pricing, 1994. McGraw-Hill & Co.
The volatility smile effect is observed only for some single stocks and is not a feature of index options,
which exhibit negative skew. We compare and contrast index option skew patterns with the smile
pattern in the following pages.
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Volatility Handbook
Implied volatility strike structure for equity index options usually does not follow the same
pattern as described above for some individual stock options, due to subtle differences in
the way the market views the likelihood of large price swings occurring for stocks versus
indices. As Figure 7 illustrates, equity index options exhibit a downward sloping strike
Strike structure of equity index
options
structure that is highest for the OTM strikes and decreases as the strike prices move
inin-thethe-money. This strike structure pattern is known as negative skew, which shows an
underlying market belief that a price swing to the downside is much more likely than to
the upside. We define strike prices as a percentage of the underlying asset value
(thereby making the 100% strike equivalent to the ATM strike).
Indices are thought to have a

greater probability of
downside price movements,
which is expressed in the
negative skew of index
option implied volatility.
Figure 7: Implied Volatility Strike Structure of 3-Month S&P 500 Options

40%
3-Month Strike Structure of Impl Vol

3-Month 90% - 100%Strike Skew of Impl Vol
35%
30%
25%
The differentials shown on the

right describe the slope of the
curve between the 90% and
100% strike. A steep slope
indicates a large drop in
implied volatility between the
strike prices.
Current
Avg
SD
SD Units
Steep/Flat Indicator
5.7%
5.1%
1.1%
0.54
Fairly Steep
20%
15%
10%
80% Strike
90% Strike
100% Strike
110% Strike
120% Strike
Current
31.6%
25.9%
20.2%
16.9%
14.2%
One Week Ago
29.6%
24.2%
19.1%
15.9%
13.2%
One Month Ago
30.8%
25.2%
20.4%
17.3%
16.2%
3-Yr Avg +2 SD
38.6%
32.6%
26.9%
22.6%
21.2%
3-Yr Avg -2 SD
26.1%
21.6%
17.6%
14.8%
13.2%
1-Month 90% - 100% Strike Skew of Impl Vol

Current
Avg
SD
SD Units
Steep/Flat Indicator
6.6%
8.1%
2.7%
-0.56
Fairly Flat
Strike Structure Differences Between

Between Single Stock Options and Equity Index Options
We have thus far concluded that strike structure of implied volatility is determined by
market perception of the likelihood of large price movements in either direction. When
the market views large upside and downside moves as being equally likely, implied
volatility skew takes on a balanced volatility smile shape. The negative skew of index
option implied volatility means that the market believes that index prices are much more
10
likely to swing down than up., but why? Two reasons have been offered :
n Stock markets and sectors have a larger downside correlation than upside
Why does index option strike

structure differ from single
stock option strike structure?
correlation (i.e., stocks tend to drop together in falling markets more often than
they increase together in rising markets)
Graph shows a snapshot of 3-month strike structure as of Feb 5, 2002. For a daily update of global
index strike structure, contact your Lehman Brothers sales representative.
10
Natenberg, Sheldon, Option Volatility and Pricing, 1994. McGraw-Hill & Co.
February 2002
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Volatility Handbook
n Stock index options are very commonly used to hedge long equity portfolios,
making demand for put options much higher than call demand, and consequently
raising index put premiums relative to call premiums. Asymmetrically high put
demand and put premiums will skew put implied volatility to the downside for
index options.
We explore the arguments for greater index downside skew:
Extensive prior research has suggested an asymmetric correlation in equity sector returns
11
during bull and bear markets. Specifically, sector correlation is higher during periods of
12
negative return , which leads to different volatility implications for single stocks and
indices. Figure 8 plots the average downside and upside inter-sector correlation for nine
13
market sectors
and the S&P 500 index option implied volatility from October 1995 to
October 2001.
Figure 8: Average Sector Index Downside and Upside Correlations from October
1995 to October 2001
Market
During periods of high market

implied volatility, which is
associated with falling returns,
market correlation is higher than on
the upside. This asymmetry in market
correlation causes the negative
implied volatility skew present in
index options.
Downside
Ups ide
High implied volatility and

high downside correlation
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0.6
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10/27/97
4/27/97
1/27/97
7/27/96
10/27/96
4/27/96
1/27/96
10/27/95
0.2
As we stated in our earlier analysis, the graph in Figure 8 suggests that average upside
and downside sector correlation move together except in periods of low or high option
implied volatility, such as October 1997 and August 1998 (Southeast Asian Crisis and
Russian debt crisis respectively), when downside correlation spikes.
11
See Longin F. and B. Solnik, 2001, Extreme Correlation of International Equity Markets, Journal of
Finance, 56, 649-676.
12
13
See Not All Momentum Sectors are Created Equal, in November 12, 2001, issue of The Outlook.
From a prior analysis conducted on November 12, 2001. The nine sector indices are Banks (BKX),
Biotechnology (BTK), Consumer Staples (CMR), Cyclicals (CYC), Pharmaceuticals (DRG), High
Technology (MSH), Semiconductor (SOX), Broker/Dealer (XBD) and Utilities (UTY). Our analysis used a
22-day period (calendar month) to calculate inter-sector correlation. The average inter-sector correlation is
a 22-day moving average of the 36 pair-wise inter-sector correlations.
18
February 2002
Volatility Handbook
Indices exhibit asymmetric return distributions that are historically skewed to the negative
tail. Furthermore, these distributions also have a higher level of kurtosis than exhibited by
a normal distribution.
14
Examined together, negatively biased asymmetry and higher
kurtosis imply that indices, as empirical research would suggest, have more downside
risk than a single stock. The discrepancy between index and single stock option strike
structure volatility occurs on the put side, precisely because of the greater index tendency
for downside moves. This perceived asymmetric downside index tendency raises the
value of OTM index puts and lowers the value of ITM puts. Single stock ITM puts have
similar premiums to OTM puts, because markets perceive single stocks to have a
relatively equal chance of moving significantly up or down.
While term structure is useful in identifying the ideal time horizon to execute a strategy,
skew can help identify the appropriate strike prices based on market expectation of
relative volatility. For example, the strike structure in Figure 7 drops more steeply from the
OTM strikes leading up to the ATM strike than it does after, which indicates that the
market expects higher volatility (and higher premiums) on that portion of the skew curve.
Real-Time Implied Volatility Market Indicators
The Chicago Board Options Exchange (CBOE) offers real-time indices that track shortterm index implied volatility on the S&P 100 (OEX) and the Nasdaq-100 (NDX).
VIX Index (shows implied volatility of S&P 100)
15
The VIX was developed in 1993 as an indicator of market implied volatility, and is often
regarded by technical analysts as a contrary market indicator, meaning it moves
inversely with the market. Since it measures implied volatility, VIX increases as the market
declines (showing higher implied volatility) and vice versa. Low VIX levels signify low
implied volatility and relatively complacent markets. Extremely high VIX levels indicate
high anxiety, risk and uncertainty in the options market and generally coincide with a
continued decline in stock prices.
16
VXN Index (shows implied volatility of Nasdaq-100)
Similar to the VIX, the VXN Index gauges implied volatility on the Nasdaq-100,
providing investors with a real-time volatility barometer for the technology universe.
Compared to the VIX, which tracks the relatively more stable S&P 100 index, the VXN
shows the higher implied volatility inherent in technology stocks.
14
Kurtosis measures how much of a distributions variability lies at the extremes (i.e., the thickness of the
tails).
15
The VIX index replicates the payoff of a hypothetical ATM option expiring in 30 days. The option is
composed of eight puts and calls on the underlying OEX weighted by time to expiration and the ATM
strike price.
16
Uses NDX options and the same construction methodology as the VIX.
February 2002
19
Volatility Handbook
A Note on Contrary Market Indicators

It is important to clarify the relationship between VIX and VXN levels and market activity.
Implied volatility, as earlier defined, is the volatility implicit in option prices, and has an
inverse relationship to the market. Implied volatility is not reflective of the size of price
17
swings, but of the implied risk associated with the stock market.
As mentioned before,
sector risk (and hence market risk) has an asymmetric negative bias, which means that
market declines are associated with higher overall levels of risk and higher implied
volatilities. For evidence of rising implied volatility in risky markets, we can look no further
than the VIX and VXN spike in Figure 9 caused by the additional risk that the events of
September 11 injected into the markets. Put option implied volatility is the most likely to
rise in a falling market as investors seek protection; the spike in put activity also causes
premiums to rise.
Figure 9: Daily 2001-2002 VIX and VXN Volatility Index Levels

The VIX and VXN indices
developed by the CBOE
track implied volatility of the
S&P 100 and Nasdaq-100
respectively. The two are
regarded as barometers of
implied volatility in the
options markets.
90.0
80.0
70.0
Volatility (%)
60.0
50.0
40.0
30.0
20.0
10.0
1
9/
2/
01
10
/2
/0
1
11
/2
/0
1
12
/2
/0
1
1/
2/
02
2/
2/
02
VIX Level
8/
2/
0
7/
2/
0
6/
2/
0
5/
2/
0
4/
2/
0
1/
2/
0
1
2/
2/
01
3/
2/
01
0.0
VXN Level
QQV Index (shows implied volatility of options on the Nasdaq-100 ETF)

The Nasdaq-100 Index Tracking Stock (ticker symbol QQQ) is the most popular
example of a relatively new investment vehicle known as an exchange traded fund
18
(ETF).
The QQV Index (quoted on the American Stock Exchange) was developed in
September 2000 to track the implied volatility of options on the QQQ. The methodology
is similar to that used by the CBOE in calculating the VIX and VXN.
20
February 2002
17
From the CBOE website (www.cboe.com)
18
ETFs are introduced and described in Section 3.2.
Volatility Handbook
Volatility Cones
Just as term and strike structure display market perceptions of implied volatility, volatility
cones show technical and momentum trends in historical volatility over time. The volatility
cone in Figure 10 condenses implied and realized index volatility data, and shows nearterm volatility spread trends to make an effective trading tool.
Figure 10: S&P 500 Implied and Realized Volatility Cone and Near-term Volatility
19
Spreads
A volatility cone is useful in
identifying trading
opportunities caused by
discrepancies in realized and
implied volatility levels.
Near-Term ATM Implied Vol & Realized Vol
Realized Volatility Cone & Current ATM Implied Vol

40%
45%
40%
1-Mth Realized Vol

Near-ATM Impl Vol
35%
30%
30%
25%
20%
15%
10%
20%
Vol Spread (Near-ATM Impl - 1 Mth-Realized)
10%
Vol Sprd
3-Yr Avg Vol Sprd -2 SD
Near-ATM Impl Vol
3-Yr Avg Vol Sprd

3-Yr Avg Vol Sprd +2 SD
20%
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
15%
0%
10%
1-Mth 2-Mth 3-Mth 4-Mth 6-Mth 9-Mth
1-Yr
2-Yr
3-Yr
Min Realized
9.1% 11.0% 12.9% 13.2% 17.0% 17.2% 17.9% 19.2% 17.3%
Max Realized
35.5% 30.6% 28.6% 27.1% 26.0% 24.1% 23.1% 21.8% 21.7%
Avg Realized
19.8% 20.2% 20.4% 20.4% 20.7% 21.0% 21.0% 20.5% 19.8%
5%
0%
-5%
-10%
-15%
Current Realized 17.6% 16.4% 15.8% 17.0% 19.6% 18.7% 20.8% 21.4% 20.5%
Current Implied
20.9% 20.9% 20.8% 20.5% 20.4% 20.3% 20.4% 21.1% 21.7%
Profitable relative volatility trades can be executed on discrepancies between implied

and realized volatility or current and historical levels of realized volatility. Cones are also
useful tools to compare relative volatility levels of two stocks or indices. The shape of a
volatility cone illustrates the long-term mean reverting property of volatility. The cone is
widest for the near-term expirations, which are susceptible to the widest fluctuations, but
the range narrows as the time horizon is extended.
19
Graph provides a snapshot of S&P 500 historical and implied volatility as of February 6, 2002.
Contact your Lehman Brothers Sales Representative for current levels.
February 2002
21
Volatility Handbook
22
February 2002
Volatility Handbook
Section 3: Trading Volatility
February 2002
23
Volatility Handbook
Option Strategies to Trade Volatility

Most investors have a view on a single stock, sector or index and how they think its price
will vary over a given future time frame. Options are an efficient and cost-effective way
to implement trading positions designed to profit on an investors views on the market.
There are two basic factors that should help determine an appropriate strategy:
n View on the Underlying Asset: What factors does the investor believe will drive
the value of a stock or index over a given time period in the future? These could
be fundamental factors or technical/momentum driven factors.
n Current and Future Volatility Levels: How high or low are current implied and
realized volatility levels relative to each other? How high is current realized
volatility relative to past levels of realized volatility?
In Figure 11 below, we show appropriate option strategies to implement various views
on underlying asset price movement and volatility levels.
Figure 11: Option Strategies for Expectations of Momentum and Volatility

Expect Price Increase
Expect Increased
Volatility
Expect Stable
Volatility
Expect Price Stability
Expect Price Decrease
Buy Calls
Buy Straddles or
Strangles
Buy Puts
Bullish Spread Strategies
Long-Short Strategies
Bearish Spread Strategies
Sell Puts
Sell Straddles or
Strangles
Sell Calls
Expect
Decreased
Volatility
The basic strategies outlined above can be combined to capitalize on current market
conditions. We outline the mechanics of the basic strategies and possible combinations
to profit from expected market and volatility movements in Figure 12.
24
February 2002
Volatility Handbook
Figure 12: Basic Description of Basic Option Strategies

Strategy
Name
Strategy Components
Possible Uses
Buy Calls
Buying Calls
Strongly bullish risks entire premium for upside

movement in underlying, uses less capital than
buying the underlying outright. Potential entry
strategy.
Sell Calls
Sell calls with no position in

underlying stock
Extremely bearish unlimited risk potential since

there is no existing position in the underlying asset.
Call
Overwriting
Selling calls with an existing

long position in underlying
Income strategy/Exit strategy either take in

premium or sell off long position at a favorable
price. Strategy can also be accomplished by
simultaneously buying the underlying asset and
selling calls to finance the purchase.
Buy Puts
Buying Puts
Strongly bearish a low cost short or insurance

against loss on long position.
Sell Puts
Selling Puts
Strongly bullish entry strategy or potential income

strategy. The risk is a potentially forced long
position if sold put is exercised.
Call Debit
Spreads
Sell high strike call, buy lower

strike call
Moderately bullish willing to risk capital for

limited upside with less risk than outright call
buying.
Call Credit
Spread
Buy high strike call, sell lower

strike call
Moderately bearish seek to take in premium with

limit to potential loss
Put Debit
Spreads
Buy high strike put, sell lower

strike put
Moderately bearish willing to risk capital for

downturn in underlying but not to the degree of
outright put buying
Put Credit
Spread
Sell high strike put, buy lower

strike put.
Moderately bullish seek to take in premium with

limit to potential loss
Long Straddle
Buy a put and a call at the

same strike price.
See movement in underlying away from strike, but

not sure of the direction
Short Straddle
Sell a put and a call at the

same strike price.
See little movement in underlying away from the

strike in either direction.
Long Strangle
Buy a put and a call at

different strikes (call strike
higher, put lower)
See movement in underlying away from range

between strikes. Cheaper than long straddle but
more risky.
Short Strangle
Sell a put and a call at

different strikes (call strike
above, put below)
See price of underlying remaining within the range

between strikes until expiration. Less risky than
short straddle, but less profitable.
Collar
Buy an out-of-the-money put

and sell an out-of-the-money
call.
A collar is designed to protect a long position in

the underlying. The insurance put is financed, at
least partially, by the selling of the call, which
represents the upside potential of the underlying.
Selecting Appropriate Strike Prices for Out-of-the-Money Options

The option strategies above are each combinations of call and put options with different
relative strike prices If a desired strategy recommends buying or selling OTM strike
options, the appropriate strike price is critical. Option premiums decrease as strike prices
get further out-of-the-money, reflecting the lower probability that the strike price will be hit
before expiration. We outline a methodology for choosing OTM strike prices and the
trade-off between income (cost) and downside protection (upside potential):
February 2002
25
Volatility Handbook
Buying OTM Options: Strike price should be set at a level where the investor believes
the premium paid is worth the potential upside and the probability that it will be reached.
Sell OTM Options: Strike price should be set at the investors optimal trade-off between
current income and protection. Defensive-minded investors will likely opt to collect a
lower premium by selling a further OTM option in return for the added protection
provided by the higher strike.
We provide graphical illustrations of the payoffs of the basic options strategies described
above in Figure 13.
Figure 13: Illustrations of Option Strategy Payoffs

Call Overw riting
Call Debit Spread
26
February 2002
Collar Strategy
Call Credit Spread
Volatility Handbook
Put Debit Spread
Put Credit Spread
Long Straddle
Short Straddle
Long Strangle
Short Strangle
February 2002
27
Volatility Handbook
New Developments in Equity Derivatives: The Exchange Traded Fund (ETF)

What is an ETF?
20
An ETF is a hybrid security that is traded on an exchange, like a single stock, but
provides the returns from owning a portfolio of stocks.
The portfolio could represent
either an entire market (such as the S&P 500, or the Nasdaq-100, Russell 3000, the
FTSE 100 etc.), a sector or industry of the market (Internet, Telecommunication, Financial
services, Energy, Technology, Real Estate, etc.) or even a selected basket of stocks.
Although the current ETFs track or replicate well-known market indices, plans are under
way to introduce ETFs that represent any actively traded portfolio of stocks.
Brief History of ETFs
ETFs have grown in popularity since their origin in 1993. The first ETF, called Standard
and Poors Depository Receipts (SPDRs, known
21
as spiders), tracks the performance of
the S&P 500 index much like a mutual fund. With a current estimated asset base of
about $20 billion, it has more than 100 million shares outstanding. By far the dominant
ETF on the market today, SPDRs have more than 40% of the market share of all ETF
assets, and institutions own nearly 40% of SPDR shares.
Another widely popular ETF tracks the Nasdaq 100 index and trades under the ticker
22
symbol QQQ. Launched in March 1999,
QQQs have quickly become one of the
most actively traded securities on any of the U.S. stock exchanges.
Currently, the
QQQs have two-thirds the assets of SPDRs (approximately $11 billion) but trade nearly
twice the average daily dollar volume of the latter. On average, QQQs traded slightly
over 70 million shares a day in 2001, making them one of the most liquid securities
traded on any exchange.
Investment Strategies Using Exchange-Traded Funds
ETF enabled investment
strategy
Part of the excitement surrounding the introduction of ETFs is due to the facilitation of new
investment strategies they make possible. It is a well known fact that asset allocation
decisions are significant determinants of superior investment performance.
ETFs that
represent aggregated units of the market (sectors, styles, sizes, etc.) are ideally suited to
implement asset allocation decisions. In what follows, we establish the need for asset
allocation strategies to achieve superior returns and to forecast asset returns In addition
to asset allocation, we list potential investment strategies executed efficiently with ETFs.
ETFs and Futures Contracts
Equity asset managers that are benchmarked to a major index have alternative methods
of investment to achieve the performance of their benchmark. The obvious approach is
to own the stocks in the benchmark index in a portfolio that is weighted according to the
benchmark's weighting methodology.
However, real world issues such as index
20
See Exchange-Traded Funds: Where the Market is a Stock, September 15, 2000 publication by
Lehman Brothers Equity Derivatives & Quantitative Research.
21
22
28
February 2002
SPDRs are managed by State Street Global Investors.

QQQs are managed by the Bank of New York.
Volatility Handbook
changes, cash management, dividends, corporate actions, redemptions and trading

costs precipitate inefficiencies in this simple approach. For instance, when the asset
manager receives cash from dividends paid, he should transform that cash position into
index exposure. The job of managing an index portfolio becomes quite dynamic since
he is receiving dividends with regularity and simultaneously managing cash inflows or
outflows.
Couple the cash management issues with changes in the benchmark from
reconstitutions and M&A activity and things can get pretty complicated. Fortunately, for
some index managers, they have the ability to use other methods to obtain performance
exposure to his or her benchmark. Namely, the fund manager can use futures contracts,
exchange traded funds and options to make his job more efficient. However, many
index managers are prohibited by the fund's bylaws from trading in derivative products.
For these managers, ETFs are a non-derivative solution.
Because of their lower transaction costs and minimal margin requirements, equity index
futures can play an important role for the index manager.
An index manager that
requires exposure to a benchmark index can make the appropriate investment in the
futures contract. Then the asset manager can either roll into the next futures contract as
time passes or let the position expire and invest in the actual stocks. Historically, the
futures contract was ideal for obtaining index exposure for extended periods of time,
however more recent times have seen the cost of holding a futures position for an
extended period of time become more costly.
This cost is called the calendar spread and is measured as the annualized spread of the
roll cost of closing the near futures contract and opening a position in the next futures
contract versus the current risk free rate. If the calendar spread trades at fair value the
roll cost is zero. If the calendar spread is trading over the fair value the investor incurs
roll cost, however, the calendar spread can trade cheap which is a benefit. Figure 14
illustrates that the calendar spread trade has generally traded rich since 1995.
Figure 14: S&P 500 Calendar Spread 1988-2001

1 .5
1 .0
0 .5
0 .0
- 0 .5
- 1 .0
- 1 .5
- 2 .0
- 2 .5
- 3 .0
Aug-00
Aug-99
Aug-98
Aug-97
Aug-96
Aug-95
Aug-94
Aug-93
Aug-92
Aug-91
Aug-90
Aug-89
Aug-88
Aug-87
- 3 .5
February 2002
29
Volatility Handbook
Our analysis looks at the costs that an investor would incur for both products if the
investor were to hold the investment for one year. The breakdown of the costs is as
follows:
ETFc = C + B/As + AF
Fut c = C + B/As + R r
Where:
C = Commission cost (round trip or buy + sell)
B/As = Impact cost reflected as the bid/ask spread
AF = Advisor fee for the ETF
Rr = Roll cost
The costs that are common to both the ETF and the futures contract are commissions and
the bid/ask spread. However, these costs are very different for each product. It is well
known that the commission cost associated with futures contracts are very low when
compared to the notional size of a transaction. We use an estimate of $15 a contract,
which currently amounts to 0.4 basis points. Commissions for the ETF are higher, we
assume a rate of 6 cents per share, or currently 4 basis points. The bid/ask spread also
favors the futures contract. For our analysis we use a bid/ask spread of 0.5 index
points, or in terms of dollars, 0.5 multiplied by $250 (or $125 per contract or 4 basis
points). The bid/ask spread for the ETF is 10 cents, or 8 basis points. The figures used
for both commissions and the bid/ask spreads are provided by Lehman Brothers trading
desk.
The unique cost to each product is where the separation occurs. The unique cost of the
ETF is the advisor fee and the unique cost of the future is the roll cost.
The ETF is a managed trust for which the investment advisor of the trust charges a fee.
This fee is typically comprised of management fees, distribution fees and other fees. The
S&P 500 exchange traded funds have the lowest fees of all existing ETFs. The advisor
fee charged by the iShares S&P 500 index fund is 9 basis points, and the S&P 500
SPDR carries a fee of 12 basis points. We use the lower of the two fees for our cost
analysis.
The cost of holding a future for any length of time that requires the contract holder to
enter into a calendar spread trade. The roll cost is the premium an investor pays for
selling the futures contract that is closest to maturity while simultaneously buying the futures
contract with the next-closest maturity. Investors that were long June 2001 S&P 500
futures contracts and wanted to continue holding a long position in S&P 500 futures
contracts had to roll into the September 2001 contracts by executing a calendar spread
trade prior to the expiration of the June 2001 contract.
30
February 2002
Volatility Handbook
Figure 15 shows the scenario of an investor with a one-year holding period. We use
100 futures contracts to establish the notional amount of this trade to be roughly $30
million. The comparison shows a dramatic difference in cost for a buy and hold investor.
The roll cost of the future dominates the analysis, and tilts the scales in favor of the ETF.
However, the roll cost is not a certain cost. The roll cost of 25 basis points used in this
analysis is the average daily roll cost in the four weeks leading up to contract expiration
as measured in the last four quarters. The roll cost is a variable, and could even be
negative under certain market conditions.
Figure 15: One-Year Holding Period Costs of Futures versus ETFs

S&P 500 Future
S&P 500 ETF
100 Contracts @ $304,625 each

$30,462,500
250,103
$30,462,545
6 cents a share or $15,006
Bid/Ask Spread
$15 a contract or $1500 * 4 or

$6,000
.5 * $250 * 100 contracts or 12,500
Management Fees
N/A
.0009 * 30,462,545 or 27,416

yearly
Roll Cost
Total Cost for One
Year Holding Period
Total Cost/Notional
25 bps or $76,156 yearly

94,656
N/A
67,432
0.31%
0.22%
Position
Notional Amount ($)
Cost Category
Annual Commission
.10 * 250,103 or 25,010
Option Strategies for ETF Holders

ETF investors can implement a variety of option-based strategies that can potentially
enhance returns and lower risk on their ETF investment. Listed options are not available
for all available ETFs, but some of the more liquid ETFs do have listed options. For
investors that wish to implement an option strategy on ETFs that do not have listed options
available, they can implement their strategy with OTC (over the counter) options.
Additionally, OTC options might provide further flexibility and customization for investors
over and above what is provided by the listed market.
Here we present a few strategies that involve options and a position held in an ETF. The
common theme in the strategies is to provide the investor that has a directional view
(bullish or bearish) with potentially yield enhancing strategies that can also lower the
overall risk taken in the position. Figure 16 is a table of ETFs trading in the United States
that have listed option contracts.
February 2002
31
Volatility Handbook
Figure 16: U.S. ETFs with Listed Options

Fund Name
Symbol
Average Daily Option Volume
Nasdaq-100 Index Tracking Stock
QQQ
66,112
Biotech HOLDRs
BBH
8,243
Semiconductor HOLDRs
SMH
2,809
Oil Services HOLDRs
OIH
1,176
iShares S&P 100 Index Fund
OEF
713
Pharmaceutical HOLDRs
PPH
243
Internet HOLDRs
HHH
238
Internet Architecture HOLDRs
IAH
96
Telecommunications HOLDRs
TTH
94
iShares Russell 2000 Index Fund
IWM
88
Total Stock Market VIPERs Index Fund
VTI
83
iShares Russell 2000 Growth Index Fund
IWO
81
Wireless HOLDRs
WMH
55
Internet Infrastructure HOLDRs
IIH
42
Regional Bank HOLDRs
RKH
27
Utilities HOLDRs
UTH
24
Retail HOLDRs
RTH
24
B2B Internet HOLDRs
BHH
24
iShares Russell 1000 Index Fund
IWB
20
Market 2000+ HOLDRs
MKH
18
FORTUNE e-50 Index Fund
FEF
10
Europe 2001 HOLDRs
EKH
iShares Russell 2000 Value Index Fund
IWN
Call Overwrite Strategy

An investor that currently holds a long position in a security and is neutral to moderately
bullish, can consider the call overwrite strategy to enhance yield on his/her investment.
The strategy is designed to increase the investor's return if the long position is neutral over
the period until the option's maturity. The investor collects the option premium of the
written call option and maintains his/her long position if the option expires out of the
money. The investor will outperform the simple long position without call overwriting in
all cases except where the underlying rises above the written call's strike price plus the
collected premium at maturity. In this case, the option writer will have the ETF called
away" which means that the holder of the option is exercising his or her right to purchase
the ETF at the designated strike price. The writer of the option must satisfy the option
holder by selling the ETF to the option holder at the designated strike price. The investor
who implemented the call overwrite strategy has a positive return for the period, but will
underperform a simple long position if his ETF is called away.
Hence, a buy write
strategy is not the strategy of choice if one is very bullish. It is often a strategy employed
by asset managers who are mandated to invest in a class of stocks that are neutral or
under-performing.
For instance, value managers in 1998 and 1999 and growth
managers in 2000 were well positioned to undertake a call overwrite strategy.
32
February 2002
Volatility Handbook
Figure 17: Profit/Loss Diagram of Call Overwrite Strategy
Profit & Loss
Lon g Q s & W rite

AT M C a lls
0%
15
0%
14
13
0%
12
0%
11
0%
10
%
90
%
80
%
70
%
60
%
50
0%
Lon g Q s
Equity P ric e
Put Overwrite Strategy

A feature of exchange-traded funds is the ability to short on a down tick. Additionally,
market makers will often quote an ETF transaction as a principal trade. Hence, in a
declining market, ETF investors can quickly hedge certain market/sector exposures by
entering into a short position in a declining market at a known price. Upon examining
short interest levels for SPDRs and QQQs, we see their popularity as defensive hedges.
Figure 18: QQQ Short Interest - July 1999 to July 2001
600%
140
120
100
80
60
40
20
0
400%
300%
200%
100%
S hort Int erest Rat io
Ju
l-0
1
pr
-0
01
A
nJa
ct
-0
0
l-0
Ju
pr
-0
00
Ja
n-
9
ct
-9
0%
9
l-9
Ju
500%
S hort Interes t
Q Q Q S hort Int erest
February 2002
33
Volatility Handbook
Figure 19: SPYs Short Interest - July 1999 to July 2001

35
30
25
20
15
10
5
0
S ho rt Inte re s t
400%
300%
200%
S h o rt In te re s t R a tio
1
Ju
l- 0
1
pr
-0
01
nJa
-0
ct
O
l- 0
Ju
0
pr
-0
00
n-
Ja
ct
-9
100%
0%
l- 9
Ju
600%
500%
S P Y S h o rt In te re s t
The put overwrite strategy is very similar to the call overwrite strategy, but differs in one
way: the investor is bearish and holds a short position in the ETF (the underlying). The
investor writes put options against the ETF short position and expects to collect the
premium if the ETF price is above the written puts strike price when the option expires.
The only scenario in this strategy that will under-perform the simple short position is when
the ETF price falls below the strike price of the written put option, less the collected
premium. Figure 20 illustrates the profit and loss scenario at expiration. Otherwise, the
put overwrite strategy will outperform a simple short position.
Figure 20: Profit/Loss Diagram of Put Overwrite Strategy
Profit & Loss
S h ort Q s & W rite

O u t-of-Mon e y P u ts
Equity P ric e
34
February 2002
0%
12
0%
11
0%
10
%
90
80
S h ort Q s
Volatility Handbook
Conclusion
Presuming returns can be forecast, ETFs are a cost-efficient way to implement strategies
or views at the sector level. Prior to the creation of ETFs, investment managers had to
trade in portfolios of securities to gain exposure to the relevant size, style or sectors. This
caused higher transaction costboth in trading and management of those portfoliosin
the implementation of active asset allocation strategies. We highlighted the major
benefits of ETFs: lower transaction costs, breadth of asset class coverage, transparency
in pricing and liquidity.
We also presented a list of potential investment strategies for which the ETFs would
prove to be ideal instrument of execution. For these reasons, we believe ETFs are likely
to show increasing acceptance globally in the near future. The impending introduction of
ETFs in the world of actively managed funds (and hedge funds) can only increase their
acceptance and broad appeal as an instrument of asset allocation strategies. Below we
provide lists of index ETFs available by asset class, sector and geographic region.
February 2002
35
Volatility Handbook
List of Available ETFs on Selected Indices
Figure 21: List of Currently Available ETFs Related to Style (Growth/Value) Asset Class
Ticker Name
Avg
Outstanding
Assets (m) Bid/Ask
Shares (m)
Spread
Average
Dollar
Volume
Inception
Date
IVW iShares S&P 500/Barra Growth
0.95
1,246,375
5/26/00 0.25%
86.30
0.50%
Advisor Fee
IVE
iShares S&P 500/Barra Value
0.70
43.99
0.74%
1,981,290
5/26/00 0.18%
IJK
IJJ
IJT
iShares S&P Midcap 400/Barra Growth 0.25
36.44
0.40%
269,892
7/28/00 0.25%
IJS
iShares S&P Midcap 400/Barra Value
0.25
19.32
0.68%
109,023
7/28/00 0.25%
iShares S&P SmallCap 600/Barra

Growth
0.20
17.54
0.65%
302,457
7/28/00 0.25%
iShares S&P SmallCap 600/Barra Value 0.20
14.37
0.68%
256,443
7/28/00 0.25%
5/26/00 0.20%
IWF iShares Russell 1000 Growth

IWD
IWO
IWN
IWZ
IWW
0.50
44.77
0.53%
1,464,657
iShares Russell 1000 Value
0.45
25.84
0.83%
1,628,253
5/26/00 0.20%
iShares Russell 2000 Growth
0.35
29.12
0.81%
3,596,446
7/28/00 0.25%
0.35
37.71
0.59%
588,526
7/28/00 0.25%
iShares Russell 3000 Growth
0.25
17.72
0.58%
28,616
7/28/00 0.25%
0.25
18.35
0.68%
22,258
8/4/00
0.25%
Source: Bloomberg
Note: Average Bid/Ask Spread and average dollar volume is calculated over the last 30 days. Additionally, outliers are
eliminated from the average calculation. All funds mentioned above are managed by Barclays Global Advisors Ltd.
Figure 22: Currently available ETFs related to size (large/medium/small) asset class
Avg
Outstanding
Assets (m) Bid/Ask
Shares (m)
Spread
Average Dollar
Dollar
Volume
Inception
Date
0.50%
660,989,952
1/29/93
0.12%
0.82%
1,644,067,456 3/10/99
0.18%
55,934,068
5/4/95
0.25%
Ticker
Name
SPY
S&P 500 Depositary Receipt
118.92
17,957
QQQ
MDY
IVV
DIA
IWB
IJH
Nasdaq-100 Shares
128.95
12,677
2,704
0.98%
IWM
IJR
IWV
IYY
S&P 400 Mid-Cap Dep Recpt 27.46
Advisor Fee
iShares Trust -S&P 500
11.85
1,788
0.30%
37,165,872
5/19/00
0.09%
Diamonds Trust Series I
13.75
1,534
0.18%
75,368,688
1/20/98
0.18%
iShares Trust - Russell 1000
3.40
274
0.56%
520,743
5/19/00
0.15%
iShares S&P Midcap 400
2.30
247
0.45%
7,339,662
5/26/00
0.20%
iShares Russell 2000
2.25
238
0.51%
9,733,797
5/26/00
0.20%
iShares S&P SmallCap 600
0.40
44
0.44%
1,296,404
5/26/00
0.20%
iShares Russell 3000
0.40
33
0.58%
762,961
5/26/00
0.20%
iShares Total Market
0.15
11
0.67%
737,789
6/16/00
0.20%
Source: Bloomberg
Note: Average Bid/Ask Spread and average dollar volume is calculated for the last 30 days. Additionally, outliers are
eliminated from the average calculation. All funds mentioned above are managed by Barclays Global Advisors Ltd.
36
February 2002
Volatility Handbook
Figure 23: Currently Available ETFs Related to Industry Sectors

Ticker Name
Avg
Outstanding
Assets (m) Bid/Ask
Shares (m)
Spread
Average Dollar
Inception Date FUND ADVISOR
Volume
Advisor
Fee
BBH
XLK
HHH
BHH
PPH
BDH
TTH
XLF
IIH
IAH
XLE
XLP
SMH
IYW
XLB
IYF
XLY
XLU
RKH
XLI
XLV
IYV
IYG
UTH
IYZ
IYE
IDU
IYJ
IYH
IYR
IYD
IYC
IYK
IYM
10.38
25.70
7.61
14.77
6.27
6.03
7.83
16.35
7.43
3.30
9.80
10.40
2.14
1.05
5.65
1.35
4.05
3.10
0.84
2.75
2.70
1.05
0.70
0.58
0.70
0.60
0.40
0.45
0.40
0.30
0.45
0.25
0.30
0.25
112,064,984
11,043,542
52,551,772
11,136,547
7,261,594
8,282,052
8,634,823
5,920,272
6,709,044
6,079,403
5,938,700
3,120,345
51,862,336
612,775
1,079,652
991,326
1,836,920
1,302,966
2,223,733
1,183,489
998,868
1,388,982
258,837
1,812,575
211,264
363,807
507,014
85,491
788,298
3,117,377
4,338
8,940
17,833
8,971
*
0.28%
*
*
*
*
*
0.28%
*
*
0.28%
0.28%
*
0.60%
0.28%
0.60%
0.28%
0.28%
*
0.28%
0.28%
0.60%
0.60%
*
0.60%
0.60%
0.60%
0.60%
0.60%
0.60%
0.60%
0.60%
0.60%
0.60%
Biotech Holdrs Trust

Technology Select Sector
Internet Holdrs Trust
B2B Internet Holdrs Trust
Pharmaceutical Holdrs Trust
Broadband Holdrs Trust
Telecom Holdrs Trust
Amex Financial Select Spdr
Internet Infrastructure Hold
Internet Architect Holdrs Tr
Amex Energy Select Spdr
Amex Consumer Staples Spdr
Semiconductor Holdrs Trust
iShares Trust-Dow Jones Tech
Amex Basic Industries Spdr
iShares Dow Jones Financial
Amex Cycl/Trans Select Spdr
Utilities Select Sector Indx
Regional Bank Holders Trust
Amex Industrial Select Spdr
Amex Consumer Svc Select Spd
iShares Trust -Dow Jones Int
iShares Trust US Financial Services
Utilities Holders Trust
iShares Dow Jones Telecomm Sector
iShares Dow Jones Energy Sector
iShares Dow Jones Utilities
iShares Dow Jones Industrials
iShares Dow Jones Healthcare
iShares Dow Jones Real Estate
iShares Dow Jones Chemicals
iShares Dow Jones Consumer Cyclicals
iShares Dow Jones Consumer Non Cyc
iShares Basic Materials
2,004
1,425
876
735
590
568
514
457
438
343
319
250
206
140
113
111
103
88
87
86
82
81
66
60
37
32
32
29
25
22
17
15
12
9
1.46%
1.40%
1.35%
1.24%
0.54%
0.53%
1.03%
1.80%
1.18%
0.56%
1.62%
1.99%
0.72%
0.48%
2.39%
0.71%
1.79%
1.72%
0.64%
1.60%
1.63%
0.87%
0.62%
0.67%
1.07%
1.19%
0.87%
0.97%
0.91%
0.85%
1.52%
1.01%
1.41%
1.81%
11/23/99
12/31/98
9/23/99
2/24/00
2/1/00
4/6/00
2/1/00
12/22/98
2/25/00
2/25/00
12/22/98
12/22/98
5/5/00
5/19/00
12/22/98
5/31/00
12/22/98
12/22/98
6/23/00
12/22/98
12/22/98
5/19/00
6/21/00
6/23/00
5/26/00
6/16/00
6/20/00
7/14/00
6/16/00
6/19/00
7/28/00
6/28/00
6/16/00
6/20/00
Merrill Lynch
State Street Global Advisors
Merrill Lynch
Merrill Lynch
Merrill Lynch
Merrill Lynch
Merrill Lynch
Merrill Lynch
Merrill Lynch
Merrill Lynch
Barclays Global Advisors
Merrill Lynch
Merrill Lynch
Source: Bloomberg
Note: Average Bid/Ask Spread and average dollar volume is calculated for the last 30 days. Additionally, outliers are eliminated from the average calculation.
Note: Expenses for HOLDRS: The Bank of New York as trustee and custodian for the HOLDRS may charge a custody fee of $2 per round lot per quarter. With
respect to the aggregate custody fee payable in any calendar year, the trustee will waive that portion of the fee which exceeds the total cash dividends and other
cash distributions received.
February 2002
37
Volatility Handbook
Figure 24: List of Currently Available ETFs Related to Country or Global Region
Ticker
Name
Avg
Average
Outstanding
Assets (m) Bid/Ask Dollar
Shares (m)
Spread Volume
Inception
Date
Fund Advisor
Advisor
Advisor Fee
IEV
iShares Trust -S&P Eur 350
0.20
16
0.61%
1,067,087
7/28/00
0.60%
EZU
iShares Trust -EMU Index Fd
0.55
42
0.58%
693,432
7/31/00
0.84%
EUN2
Dow Jones Euro Stoxx 50
7.00
324
0.46%
276,324
4/11/00
Merrill Lynch
0.50%
EUN1
Dow Jones Stoxx 50 Fund
1.10
49
0.48%
108,065
4/11/00
Merrill Lynch
0.50%
EWJ
iShares MSCI Japan Index
57.00
787
2.50%
4,302,639
3/18/96
0.84%
0.40%
ISF ln
iShares FTSE 100
10.20
158
0.59%
1,512,126
4/28/00
EWG
iShares MSCI Germany Index
7.50
154
1.84%
1,372,600
3/18/96
0.84%
EWQ
iShares MSCI France Index
3.60
96
1.62%
1,099,664
3/18/96
0.84%
EWC
iShares MSCI Canada Index
1.10
18
2.11%
873,722
3/18/96
0.84%
EWU
iShares MSCI United Kingdom
7.80
144
2.42%
711,731
3/18/96
0.84%
EWH
iShares MSCI Hong Kong Index 6.00
80
3.08%
640,669
3/18/96
0.84%
EWS
iShares MSCI Singapore Free
11.70
90
4.72%
562,150
3/18/96
0.84%
EWI
iShares MSCI Italy Index
2.25
50
1.76%
523,445
3/18/96
0.84%
EWW
iShares Mexico Index Series
2.40
39
2.74%
518,112
3/18/96
0.84%
EWM
iShares MSCI Malaysia (Free)
16.73
100
5.51%
390,791
3/18/96
0.84%
EWL
iShares MSCI Switzerland
2.88
45
2.85%
355,278
3/18/96
0.84%
0.84%
EWD
iShares MSCI Sweden Index
0.98
23
1.82%
228,864
3/18/96
EWN
iShares MSCI Netherlands
1.30
31
2.29%
228,518
3/18/96
0.84%
EWY
iShares Korea Webs Index
0.75
15
1.03%
207,283
5/12/00
0.84%
EWP
iShares MSCI Spain Index
1.65
40
1.83%
207,000
3/18/96
0.84%
EWA
iShares MSCI Australia Index
6.20
62
4.01%
202,788
3/18/96
0.84%
EWK
iShares MSCI Belgium Index
1.00
13
3.37%
143,816
3/18/96
0.84%
EWO
iShares MSCI Austria Index
1.40
11
5.60%
66,634
3/18/96
0.84%
Source: Bloomberg
Note: Average Bid/Ask Spread and average dollar volume is calculated for the last 30 days. Additionally, outliers are eliminated from the average
calculation
38
February 2002
Volatility Handbook
Cost-Effective Trading: A Look at Nasdaq-100 Derivative Products

The popularity of the index marketplace has spurred the development of innovative new
derivatives products that offer investors more freedom to tailor their exposure than ever
before. With an increased number of products offering synthetic index exposure,
transaction costs can be a big factor in choosing the right investment vehicle. We
compare and contrast the costs involved in trading three basic option products that
replicate the Nasdaq-100: NDX options, Mini-NDX Options and QQQ options.
The Nasdaq-100 Index Tracking Stock (or QQQ), an exchange-traded fund that had an
average trading volume of 70 million shares a day in 2001, is a prime example of the
vast potential for synthetic index products that appeal to a larger pool of investors.
Launched in March 1999, the QQQ is a security whose value approximates 1/40th the
value of the underlying Nasdaq-100 index and is one of the most liquid products traded
in the market today. Derivative markets around QQQs also experience heavy trading
volume, but still remain one of many options for an investor seeking Nasdaq exposure.
We also consider derivative products of the Mini-NDX (called the MNX), an exact
replication of the NASDAQ-100 that is based on 1/10th of its value.
Here, we compare Nasdaq-100 synthetic derivative products across several criteria to
determine the relative efficiency with which each product meets different investment
goals. We provide a brief description and characterize NDX derivative products by
considering differences in bid-ask spread, transaction costs of executing a trade,
frequency of expiration, settlement style and daily trading volume. Given a desired dollar
amount of Nasdaq exposure, the number of option contracts an investor would buy
depends on the value of the underlying asset. We examine total transaction cost per
contract as a function of bid-ask spread, which is a function of liquidity and demand,
and commission paid to determine the most cost-effective option. Below, we compare
March 2002 options on the NDX, QQQ and MNX.
Description of Option Products
QQQ Call: Available in $1 strike price intervals and long- or short-term expirations,
these American Stock Exchange (AMEX) traded options have the narrowest bid-ask
spread of any option studied as well as the convenience of physical settlement (upon
which the underlying QQQ shares are delivered instead of cash). As Figure 22 shows,
QQQ options are American style and therefore can be exercised early.
NDX Call: NDX options have a high premium, European style expiration, $25 strike
price intervals and a comparatively large bid-ask spread (averaging 80 basis points
wide daily in 2001 compared to 29 basis points average for the QQQ March 40
Call), which are all potentially limiting factors for investors. NDX options are also traded
February 2002
39
Volatility Handbook
on the Chicago Board Options Exchange (CBOE), which follows slightly different market
hours than the AMEX and other exchanges.
23
MNX Call MNX options are offered on the CBOE, have $5 strike price intervals. and
typically have a bid-ask spread slightly higher than that of the NDX option.
Figure 25: Comparison of NDX Options

QQQ Option
NDX Option
MNX Option
Number of Expirations
Nearest three
months plus Mar-JunSep-Dec qtrly cycle
Nearest three months

plus Mar-Jun-Sep-Dec
qtrly cycle
Nearest three months

plus Mar-Jun-Sep-Dec
qtrly cycle
Exercise Type
American
European
European
Exchange
AMEX
CBOE
CBOE
86
2001 Average Daily BidBidAsk Spread (bps)24
29
80
Position Limit (# of contracts) 25
150,000
25,000
25,000
Strike Price Intervals26
$1
$50
$5
Source: Lehman Brothers, Bloomberg, CBOE
Transaction Cost Analysis

Assuming a portfolio size of $30 million and a commission of $3.00 per contract,
equivalent to $0.03 per share, we compare the total cost of trading each option
contract using indicative prices as of January 2, 2002. The total cost is broken down
into two segments: bid-ask spread per contract purchased, a variable cost that accounts
for option liquidity and market value per contract, and the fixed cost of brokerage
commission. As Figure 25 shows, the QQQ option has the lowest total cost of trading,
since its narrow bid-ask spread more than compensates for the greater commission paid.
The total cost of trading a $30 million notional amount of QQQ options is slightly more
than $88,000, almost 1/3 the cost of trading an equivalent notional value of the NDX
or MNX options. Even after factoring in a $3 commission per contract, the QQQ Call
costs less than half the amount required to trade NDX or MNX options.
For less than half the transaction cost, QQQ options offer smaller trading increments,
greater liquidity and physical delivery, which gives an investor the option to roll over
exposure instead of cashing out upon expiration.
23
Trading hours for options on the CBOE are 8:30 a.m. to 3:15 p.m. Chicago time (one hour behind
Eastern Std Time). QQQ Options, which trade on the AMEX, have trading hours of 9:30 a.m. to 4:15
p.m. EST.
24
Average spread is calculated from daily closing bid and ask prices in 2001. Spread is shown in basis
points as a fraction of the ATM strike price.
25
The combined NDX and MNX option position limit is 25,000 contracts on the same side of the market,
with no more than 15,000 contracts in the near-term series. 10 MNX options are equivalent to one fullvalue NDX option. Exemptions may be obtained for certain public customers and proprietary accounts of
member organizations. The position limit for QQQ options will be reduced to 75,000 in February 2002.
26
40
February 2002
For NDX options, the two nearest expirations have trading increments of $25 and all others are $50.
Volatility Handbook
In Figure 26 below, we use actual option contracts on the NDX, MNX and QQQ to
compare the transaction costs associated with a hypothetical trade. The strike prices and
premiums listed are not current and used for indicative purposes only. We examine the
March 2002 option for each series.
Figure 26: Transaction Cost Comparison
Option
Option
Premium
Mkt Value
of one
Contract
No. of contracts
needed for $30
million notional
exposure
BidBid- Ask
Spread
Cost
Commission
Total Cost
Total Cost on
Notional Amt
( in bps)27
QQQ Mar
40 Call
$3
$300
7500
$88,214
$22,500
$110,714
37
NDX Mar
1660 Call
$113.50
$11350
188
$240,712
$563
$241,275
80
MNX Mar
160 Call
$10.81
$1081
1875
$259,152
$5,625
$264,777
88
27
Shows the total transaction cost as a fraction of the notional amount purchased, in this case, the
hypothetical amount chosen is $30,000,000.
February 2002
41
Volatility Handbook
42
February 2002
Volatility Handbook
Section 4: Derivatives Trading Regulation and Market

Structure
February 2002
43
Volatility Handbook
Market and Exchange Details

Futures and listed options quotes are constructed with the last letter of the ticker symbol
representing the month that the contract will expire.
Figure 27 provides the various
month codes for futures and listed options. Often a number will follow the month letter.
This number represents the year of expiration.
Figure 27: Month Codes for Futures and Options

Month
Futures
Code
March
June
September
December
Month
Jan
F eb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Calls
Puts
Source: Bloomberg, CBOE
Automatic Exercise of Options at Expiration

A listed options settlement procedure is determined by the Option Clearing Corporation
(OCC). Options that are physically settled involve the delivery of the underlying stock.
Exercise will occur automatically if the closing price of the security exceeds the strike
price by point for individual investors and point for market makers or firms. If the
closing price is less than point above the strike for individual investors or point for
market makers, the holder can choose whether or not to accept delivery. The option will
expire worthless if the holder rejects delivery.
There is no margin by which the underlying must exceed the strike for cash settled
options; hence, cash settled options will be automatically exercised if they are in the
money at expiration.
Investors who want to exercise an OTM option, or choose not to exercise an ITM option,
must submit Contrary Exercise Advice no later than 5:30 p.m. Eastern Standard on the
last business day prior to expiration.
Final Settlement Value at Expiration
The settlement value at expiration for index options and futures is determined by the
opening prices on expiration day of the index constituents for most contracts. Expiration
officially occurs on the Saturday after the third Friday of the month, unless there is a
holiday on the Friday. For equity options, the expiration settlement value is determined
using the closing price on expiration day. If a constituent stock does not open for a day,
the previous closing price in the primary market will be used to determine the settlement
price for that day.
44
February 2002
Volatility Handbook
The settlement value for options on futures at expiration is based on the opening prices
for the quarterly expirations (March, June, September and December). For all other
months, the settlement value is determined as of the closing price.
OEX options expire using the last reported sales price in the primary market of each
component stock on the last business day before the expiration date (usually expiration
week Fridays close) or on the day the exercise notice is properly submitted if exercised
before expiration.
The National Over-the-Counter (OTC) Index options use the closing prices of the last
trading day before expiration as a settlement price(usually the expiration weeks Friday
close). Some sector options also use the closing rather than opening price including, XCI,
XOI, XAU and UTY.
28
Corporate Action Adjustments

The Options Clearing Corporation determines most equity option adjustments in the
United States, regardless of the exchange they trade on. The official adjustment
guidelines are documented in Article VI, Section 11 of the OCC Rule Book, but the final
adjustment decision for existing option contracts is made at the complete discretion of the
Securities Committee, a subcommittee of the OCC.
Adjustments to option contracts are most commonly made as a result of mergers,
acquisitions or stock splits. Changes usually take place on the ex-date established by
underlying securitys market. The general rule for stock splits is that any time the split is
expressed as a ratio to 1 (e.g., 2:1, 4:1, 10:1), additional contracts are created and
the strike price is reduced accordingly. For example, the owner of one option with a
strike price of 80 on a stock that splits four-to-one will now own four options that each
have a strike price of 20. The four new option contracts leave the investor in the same
position as the single initial option contract.
If the underlying stock split results in fractional contracts (e.g., 3:2, 4:5, 7:8), then the
strike price is reduced and the number of shares that each contract represents increases
proportionally. For example, the owner of one option with a strike price of 100 on a
stock that splits three-to-two will now have a contract that represents 150 shares with a
strike price of 66. Fractional contracts are rounded to the next whole number.
In the case of dividends and distributions, adjustments are only made when the
underlying security issues a special stock dividend, defined as greater than 10% of the
market capitalization on the close of trading on the declaration date, the strike prices of
existing option contracts are adjusted proportionally. Otherwise, no adjustments are
28
XCI: AMEX Computer Technology Index, XOI: AMEX Oil Index, XAU: Philadelphia Gold and Silver
Index, UTY: Philadelphia Utility Index
February 2002
45
Volatility Handbook
made to outstanding option contracts. Upon completion of a corporate action resulting in

a new corporate entity, all outstanding contracts are adjusted to require the delivery of
the newly formed entity.
Tender offers and poison pills do not alter option contracts. In case of a property
dividend issuance, the transaction is handled on a case-by-case basis due to the
numerous possible distributions that could take place. The underlying securities of an ITM
option will be converted into rights to receive a fixed amount of cash and all OTM and
ATM options become immediately worthless.
Changes in capital structure do not affect options. If a security can be converted into a
debt instrument or preferred security, the option parameters do not change, but all interest
and dividends attributable to the underlying security becomes payable in the form of
additional units per contract.
Details of Listed Futures Contracts
In Figure 28, we provide contract and exchange details for futures available on U.S.
indices
46
February 2002
Volatility Handbook
Figure 28: Details of Futures Contracts Available on U.S. Indices

Index Name
Allowable Maximum
(Bloomberg/Reuters Stock Exchange(s) Futures Exchange and Trading
Trading
and Trading
Futures Daily Price
Codes)
Hours
Hours
Movements
Futures Codes)
S&P 500
(SPX / .SPC)
SP__ / SP__
S&P 500 (Min)

(SPX / .SPC)
Contract Tick Contract

Multiplier Size Months
NYSE, NASDAQ, CME Regular Session

AMEX hours are
8:30 15:15*
9:30 to 16:00
GLOBEX
The absolute price limits 250

are set on a quarterly
basis and are based on
percentages of 2.5%,
15:45 8:15 on Mon-Thu
5%, 10%, 15% and 20%
17:30 8:15 on Sun, holidays of the average closing
price of the lead month
futures contract in Dec,
Mar, Jun and Sept.
Same as S&P 500 Same as S&P 500
Same as S&P 500
50
Margin Limits
0.10 Mar, Jun,

Sep, Dec
Ini: 5000
Ini: 4000
0.25 Mar, Jun,

Sep, Dec
Speculator
Ini: 4688
Same as S&P 500
500
0.05 Mar, Jun,

Sep, Dec
Ini: 3750
Speculator
Ini: 13500
Same as S&P 500
500
0.05 Mar, Jun,

Sep, Dec
RD__ / RD__
Ini: 9600
Same as S&P 500
500
0.05 Mar, Jun,

Sep, Dec
Sec: 10000
Sec: 9600
Sec: 9600
Speculator
Ini: 15525
Sec: 11500
Hedger
Ini: 11500
NASDAQ
Same as S&P 500
Same as S&P 500
100
9:30 16:00
0.05 Mar, Jun,

Sep, Dec
ND__ / ND__
Sec: 11500
Speculator
Ini: 22275
Sec: 16500
Hedger
Ini: 16500
S&P/BARRA Growth Same as S&P 500 Same as S&P 500

(IGX / .SKX)
Same as S&P 500
250
0.10 Mar, Jun,

Sep, Dec
ND__ / ND__
Sec: 16500
Speculator
Ini: 15000
Sec: 12000
Hedger
Ini: 12000
Same as S&P 500
250
0.10 Mar, Jun,

Sep, Dec
ND__ / ND__
Sec: 12000
Speculator
Ini: 8348
Sec: 6750
Hedger
Ini: 6750
DJIA
(INDU / .DJI)
ND__ / ND__
Sec: 10000
Hedger
RL__ / RL__
S&P/BARRA Value
(IVX / .SZX)
Sec: 3750
Speculator
Ini: 9600
NasdaqNasdaq- 100
(NDX / .NDX)
Sec: 3750
Hedger
Ini: 10000
Russell 2000
(RIY / .RUI)
Sec: 4000
Hedger
MD__ / MD__
Russell 1000
(RTY / .RUT)
Sec: 4000
Hedger
ES__ / ES__
S&P MidMid- Cap 400
(MID / .MID)
Speculator
NYSE
Chicago Board of Trade (CBOT) Same as S&P 500
9:30 16:00
7:20 15:15
10
1.00 Mar, Jun,

Sep, Dec
Sec: 6750
Speculator
Ini: 6000
Sec: 5000
Hedger
Ini: 5000
Sec: 5000
Source: Bloomberg
* - On the last business day of each calendar quarter, settlement prices are based on sampling the 3:05 PM (Chicago time) cash index values. CME stock index
futures and options will close at 3:05 PM (Chicago time) on such days. Please note that regular settlement procedures will be observed on all other trading days
apart from the last business day of each calendar quarter. All domestic stock index futures and options, including the S&P 500, S&P Mid-cap 400, S&P?BARRA
Growth and Value Indices, E-Mini S&P 500, Nasdaq-100, E-Mini Nasdaq-100 and Russell 2000 Markets.
February 2002
47
Volatility Handbook
48
February 2002
GLOBAL EQUITY DERIVATIVES
New York
745 Seventh Avenue
New York, NY 10019 USA
1.212.526.7000
London
One Broadgate
London EC2M 7HA England
44.20.7256.4275
Tokyo
12-32 Akasaka 1-chome
Minato-ku Tokyo 107 Japan
813.5571.7357
Hong Kong
One Pacific Place
88 Queensway, Hong Kong
852.2869.3000
This material has been prepared and/or issued by Lehman Brothers Inc., member SIPC, and/or one of its affiliates (Lehman Brothers) and has been approved
by Lehman Brothers International (Europe), regulated by the Securities and Futures Authority, in connection with its distribution in the European Economic Area.
This material is distributed in Japan by Lehman Brothers Japan Inc., and in Hong Kong by Lehman Brothers Asia Limited. This material is distributed in Australia by
Lehman Brothers Australia Pty Limited, and in Singapore by Lehman Brothers Inc., Singapore Branch. This document is for information purposes only and it should
not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it. No part of this document may be
reproduced in any manner without the written permission of Lehman Brothers. We do not represent that this information, including any third-party information, is
accurate or complete and it should not be relied upon as such. It is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity.
Opinions expressed herein reflect the opinion of Lehman Brothers and are subject to change without notice. The products mentioned in this document may not be
eligible for sale in some states or countries, and they may not be suitable for all types of investors. If an investor has any doubts about product suitability, he
should consult his Lehman Brothers representative. The value and the income produced by products may fluctuate, so that an investor may get back less than he
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Additional information is available on request. Please contact a Lehman Brothers entity in your home jurisdiction.
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EQUITY DERIVATIVES

Derivatives: The Key to Risk Management

Topics are discussed with the goal of

Readers are encouraged to access the Lehman

Brothers catalog of research to gain a more thorough understanding of individual topics.

This page intentionally left blank.

Section 1: Introduction to Volatility

Finally, volatility measures the degree of variability, not the

direction of the change.

Historical or realized volatility is a backward-looking measure that

probability of reaching far in-the-money and out-of-the-money (OTM) strikes before

Implied volatility will reflect this probability, and the call

Single Stock and Equity Index Derivatives: Futures and Options

equities. Liquidity in futures contracts is generally

F0: futures price

A complete introduction to ETFs is available in Section 3.2.

Calculating Number of Futures Contracts for Hedge

# of contracts needed = b * PDV/AV

Equity options, derivative instruments offered on individual stocks, baskets of stocks,

expiration date for a certain strike price.

expiration date for a certain strike price.

Factors Affecting Option Pricing

Figure 1: Parameters Affecting Option Pricing

Change in option price with respect to time remaining

Figure 2: How Option Prices are Affected by an Increase in Parameter Value

Source: Options, Futures and Other Derivatives 4 Edition by John C. Hull

Comparison of Futures and Options

Figure 3: Payoffs from Equity Futures and Equity Options Contracts

Short Future Position Payoff

Long Future Position Payoff

Long option positions offer the

Long Call Option Position Payoff

Short Call Option Position Payoff

O ption P rem ium

Long Put Option Position Payoff

Short Put Option Position Payoff

O ption P rem ium

Source: Lehman Brothers

Section 2: Volatility Concepts and Terminology

Interpreting Implied Volatility

provide comprehensive definitions of both concepts, and illustrate their significance to

Importance of the near-term

Figure 4: S&P 500 Implied Volatility Term Structure in 2001

Source: Lehman Brothers, Bloomberg

Term structure reveals the

Figure 5: Term Structure of At-the-Money Implied Volatility of the S&P 500

Term Structure of ATM Impl Vol

1-Mth 2-Mth 3-Mth 4-Mth 6-Mth 9-Mth

1-Yr - 3-Mth Term Slope of Impl Vol

19.5% 19.9% 20.2% 19.9% 19.9% 19.9% 20.0% 20.7% 21.3%

One Week Ago

21.3% 18.3% 19.1% 19.2% 19.4% 19.7% 19.9% 20.9% 21.7%

14.8% 16.9% 17.6% 17.9% 18.3% 18.5% 18.6% 19.3% 20.1%

Source: Lehman Brothers, Bloomberg

Strike Structure (or Skew) of Implied Volatility

Each market-maker, however, has a different perception of future volatility,

Implied volatility increases

Implied volatility increases

Source: Lehman Brothers

Indices are thought to have a

Figure 7: Implied Volatility Strike Structure of 3-Month S&P 500 Options

3-Month Strike Structure of Impl Vol

The differentials shown on the

One Week Ago