Nailed It

In the Gaming the Gold Bugs post, we explored using a call ratio spread to exploit a mildly bullish move as well as elevated implied volatility in GLD. Given that today is the last trading day for November options, let's analyze how the ratio spread would have played out.

At trade inception GLD was trading around $107 with implied volatility ($GVZ) spiked up to 26%. We mentioned each volatility spike has been fade able over the past few months. Since then GLD has continued it's surge, rising as high as $113. Volatility has subsided and is currently residing around 24%

Trade Inception:

Long (1) November 109 call @ $1.30

Short (2) November 111 call @ $.78

Short (1) November 113 call @ $.50

Net Credit $.76

[Source: EduTrader]

Based on the expiration risk graph, the maximum profit will be realized if GLD is residing at $111. As long as GLD remains below $113.50, we capture some type of profit. This is where the position stands currently.

November 109 call @ $2.85 (profit = $1.55)

November 111 call @ $.90 (loss = $.12 x 2 = $.24)

November 113 call @ $.03 (gain = $.47)

Net Gain = $1.78

Since we're above $111, one would need to close the trade sometime today to avoid being assigned on the extra naked calls. Although we could say all's well that ends well, truth is GLD was getting a little too bullish when it rallied up to $113 on Wed. Given that these call ratio spreads involve shorting more options than you are buying, there is upside risk you have to worry about if the stock rallies too far. Consequently, you must remain ever vigilant in monitoring the position and managing risk.

Narrow Escape

Looks like VIX November settlement came in at $22.54. Remember you can view the settlement price via CBOE's Index Settlement Values page or via the ticker VRO. As far as I can tell the CBOE has yet to publish the data, but VRO is currently at $22.54. Looks like the opening price for the cash VIX this morning was $22.35, so the settlement price seems in line or perhaps a minor gift to those who held their short 22.50 puts into expiration. You don't cut it much closer than settling $.04 out-of-the-money.

[Source: EduTrader]

I received a question regarding selling call spreads, such as the 32.50-35, on the VIX via December options. Let me preface my answer by stating that I can't remember the last time I traded call spreads on the VIX, so my answer is coming from an objective bystander's point of view, not from a extensive experienced one. First off, since selling call spreads is a neutral to bearish bet, you'd obviously need to have that type of bias right now on VIX December futures before considering the trade. Here's how the volatility landscape stands right now:

21 day HV on SPX = 21%

Cash VIX = 22%

December VIX Futures = 24.8

So, the Dec futures are sitting around a 3 point premium to the cash. If you're of the opinion that the cash VIX is going to remain in the low 20's, and in turn Dec futures will continue to diminish over the next month, then a selling call spreads sounds feasible. The other two considerations are timing and potential profit.

Timing: Based on the nature of the VIX, particularly over the past few months, I think it's fair to say the ideal time to sell call spreads is immediately after the VIX spikes and forms a short term top, such as numbers 1-5 in the chart below (with a 10 day MA and bollinger bands). Under those circumstances you're likely to get some type of pop in the futures thereby increasing call premiums. Given that the VIX has already dropped significantly in the last 2 weeks, I'm not sure I'm in love with the timing. It would be nice to see some type of pop in the VIX before selling call spreads.

[Source: EduTrader]

Potential Profit: The other consideration is whether or not there is sufficient premium in the call spreads to make it worth your while. Currently I'm seeing the following:

Dec 32.50- 35 call spread @ $.20 credit

Dec 32.50 - 37.50 call spread @ $30 credit

Dec 30-35 call spread @ $45 credit

Based on current prices we're not dealing with a lot of potential credit. Consequently, Dec call spreads don't seem all that alluring to me at this point.

In reviewing my posts the last few weeks, it seems I've been fixated on the VIX and volatility. This is due primarily to my responses to the Volatility quiz as well as VIX expiration. For those of you that are tired of hearing volatility this and volatiltiy that, I'll see if I can mix things up a bit going forward.

VIX Expiration Dilemma

Since tomorrow is expiration for VIX options and futures, today is the last day to adjust/close out any November VIX plays trader's may have on their books. Last Thursday, I mentioned selling the November VIX 22.50 puts for $.60 credit. Fortunately the VIX has since stabilized causing the 22.50's to remain out-of-the-money. Right now the cash VIX is sitting around 23.10, with November futures trading a bit higher at 23.40. Remember, the futures will converge to the cash by tomorrow's settlement, so the discrepancy between the two will dissipate throughout the day.

Here's the dilemma: do I close out the naked puts today to lock in whatever profit I've accumulated thus far? Or, do I go ahead and ride it into tomorrow's settlement and hope we settle above $22.50, thereby capturing my entire potential profit?

It's worth mentioning this is the dilemma facing any trader short slightly out-of-the-money puts with one day remaining to expiration.

Hopefully you all know there is not one "right" answer. Trading is about trade-offs, so let's explore those associated with this particular play.

1. Close the puts sometime today to avoid the potential drama/ quirks of VIX settlement.

Pro: Closing the trade locks in the majority of potential profits and eliminates any remaining risk.

Con: Obviously if you close them now you fore go any remaining profit.

2. Hold the trade through tomorrow's open and subsequent settlement in an effort to realize max profit. This occurs if settlement price for VIX options is greater than $22.50

Pro: I get to realize my enter max profit.

Con: If the VIX tanks today and closes near or below 22.50 OR if it remains around 23 but we get a skewed settlement tomorrow, you run the risk of not only giving back what profits you've accumulated, but also incurring a loss in the trade.

What to do, what to do....

To me it's a no-brainer. If I can snatch those puts back for $.15 or less, I'm outta here... Adios amigo. In the long run, those last few cents aren't worth it in my opinion. Now, I will say if the VIX continues to trend up today, I may ride close to the bell in an effort to buy them back for as cheap as possible ($.10 or $.05), but it really depends upon market conditions.

If you think the potential risk of a crappy settlement is worth making the last $.10 or $.15, then by all means, ride to expiration. Just keep in mind you're going to get steamrolled every once in awhile. That I can almost guarantee!

Overcoming the Gap Factor

In Historical Volatility: The Gap Factor, I explored the affect that large gaps in the underlying price can have on historical volatility. Basically, these gaps artificially skew historical volatility too high such that it overstates true realized volatility for as long as the gap remains in the calculation. Take a look again at the graphic displayed in the original post (click any image to enlarge):

[Source: Livevol Pro]

Notice how the gaps that occurred during the last four earning announcements (the blue "E") caused an immediate surge in historical volatility. Once these gap days fall out of the equation (30 days later), historical volatility usually tanks, bringing it more in line with reality. This gap factor presents an interesting dilemma for those trying to use IV-HV analysis. That is to say, it is difficult to get an accurate read on whether IV is trading too high or too low compared to HV if indeed historical volatility is skewed extremely high.

The logical fix is to use a historical volatility reading that doesn't include the gap in its calculation This can be done by assessing a shorter term reading. For example, if the 30 day HV is skewed because of the gap, try looking at a 20 day or 10 day HV reading. If the gap occurred at least 11 or 21 days ago, it shouldn't be included in one or both of these calculations. Consider the following price and volatility chart on AMZN.

With HV30 around 75% and IV30 around 40%, the options seem cheap. However, is this a fair comparison? The answer is no. HV30 is skewed because of the monster earnings gap, it would be wise to look at a shorter HV measurement. We could try HV20, but since the gap took place within the last 20 trading days, HV20 will also be skewed. How about HV10? Let's take a look.

Now that the gap is out of the calculation you can see how low realized volatility truly is. Currently HV 10 is sitting around 25% or so,much lower than the 75% originally stated by HV30. With the HV10 light shed on things, options don't seem so cheap after all.

Some may argue 10 day historical volatility can be quite erratic since it encompasses such a small data set. As for myself, I'd rather deal with a more erratic reading than use one that is skewed way too high.

For other posts touching on historical volatility, readers are encouraged to read:

Historical Volatility Posts

Volatility Landscape and VIX Option Play

Per my comments on monday's VIX Sonar post, I've been stalking potential short put plays with the November VIX options. I went ahead and pulled the trigger yesterday on the NOV 22.50's, selling them at $.60 credit. Those of you who follow me on twitter are probably already aware of the trade (I tweeted it yesterday), so let me use today's post to elaborate on the rationale, starting with a recap of the current volatility landscape on the S&P 500 as of yesterday.

21 day HV = 21

Cash VIX = 23

Nov VIX Futures = 23.7

As the 21day historical volatility states, the S&P has been realizing around 21% volatility for the past few weeks. With last weeks rally, the VIX has taken it on the chin dropping to sub 23 intraday yesterday, which puts it pretty much in line with 21 HV. Remember, the VIX generally trades at a premium to realized vol, especially in 2009. Tack on the fact that the VIX was oversold by most measures, and I think we had a pretty solid thesis for selling puts.

As the chart below shows, the VIX was roughly 11% below it's 10 day simple moving average, as well as oversold based on the modified stochastic displayed (click image to enlarge).

[Source: EduTrader]

The following graphic displays the risk graph of the short NOV 22.50 put with it's corresponding profit/loss zones:

Follow me on Twitter here.

For related posts, readers can check out:

Mail Time- VIX Options

The Looming VIX Expiration

Volatility Skew and SPY Ratio Spread Update

In my post highlighting the volatility skew of SPY options, I introduced the idea of selling ratio spreads to exploit the skew as well as profit from a mildly bearish move in the underlying. You can view the post here. Fast forward two weeks, mix in a robust rally in the SPY as well as diminishing volatility, and what do we have? While I let the suspense build, let's recap the numbers from trade inception:

Oct. 28th, SPY @ $104

Buy (1) Nov 103 put for $2.00

Sell (2) Nov 100 puts for $2.40 ($1.20 apiece)

Net Credit = $.40

Take a gander at the risk graph from trade entry (click image to enlarge):

[Source: EduTrader]

Here is the current risk graph:

So what do we have? Due primarily to the rally in the SPY and partially to the declining volatility (VIX dropping from 31 to 23), the puts in play are far OTM and almost worthless. At this point we have three options:

1. Close the trade to lock in the majority of the net credit (roughly $.30)

2. Ride to expiration in an effort to realize the entire net credit (occurs if SPY remain above $103)

3. Ride to expiration in the hopes that the SPY drops below $103 into my "larger" profit zone.

The outcome of this particular trade sheds insight into one big advantage of the 1x2 put spread. Even though the SPY have risen considerably (the WRONG way), we were still able to garner a mild profit on the trade.

EDIT: By the "WRONG" way, I simply mean the direction that does not result in what I consider the ideal or largest profit.

For related posts, readers are encouraged to view the following:

Larry McMillan on Volatility

Gaming the Gold Bugs

Implied Volatility: The Supply-Demand Factor

The fourth and final question from the volatility quiz cut to the heart of the matter by asking what it means when implied volatility declines. The results weren't as stellar with this question as only 71% answered correctly by stating that when implied volatility increases, demand for that option has increased.

My guess is that some aren't clear on how supply and demand work to influence option prices, so let's see if I can shed some insight based on my understanding. Within the options market, as with any competitive market, prices fluctuate as a function of supply and demand. More demand than supply, prices typically rise. More supply than demand, prices typically fall. Just because option traders may use a theoretical pricing model, such as Black-Scholes, to derive a fair or theoretical value for each option, doesn't mean that the option prices won't fluctuate above or below that "fair value" based on supply and demand.

Assuming all other variables stay constant (time to expiration, stock price, interest rates, etc...), we could make the following assertions:

If demand for an option increases, option prices will increase. If option prices increase, implied volatility will increase.

If supply of an option increases, option prices will decrease. If option prices decrease, implied volatility will decrease.

For example, with the S&P 500 Index (SPX) currently trading around 1095, let's say the December 1000 put is worth $6.50. If we plug this value into an options calculator we can see if the 1000 put is trading at $6.50, implied volatility would be 26%

[Source: CBOE]

Let's say a big buyer comes in and aggressively buys 10,000 contracts of the Dec 1000 put. Due to this increased demand, suppose the put rises in value to $12. If all other variables remain constant, the implied volatility of the put would rise to 33%.