Thursday, December 31, 2009

My Faves of 2009

Though my Blast from the Past post included some of my greatest hits for 2009, there were a few of my favorite posts that didn't make the cut based on page views. To give them some time in the spotlight as well as assemble a list of my other notable write ups for archival purposes, I offer up the following:

Wednesday, December 30, 2009

Best and Worst Trades of 2009

An integral part of the learning process for traders is to continually identify areas of strength to capitalize on as well as areas of weakness to focus on improving. As each year comes to a close I like to take the opportunity to review my best and worst trades of the year. One of the best trading phrases I've ever heard is: Don't lose enough in one day to ruin your week, don't lose enough in one week to ruin your month, don't lose enough in one month to ruin your year. Internalizing this principle and living it is undoubtedly one of the best things any trader can do in improving their performance. Unfortunately my trading performance in July of this year was of the "lose enough to screw the year" variety. It is therefore no surprise that I'm pulling my worst trade of 2009 from July. Though most people associate July with independence, fireworks, hot dogs, and baseball games, this year it was unfortunately associated with pain, regret, and an increasing in my desire for either a crystal ball or a time machine.

If you don't remember, the market formed a beautiful head and shoulders pattern encompassing the May to June time frame.
[Source: EduTrader]

I was unfortunately lulled into a false sense of security and leaned way too much on the bear side by selling a plethora of OTM call spreads. As you can imagine the virtually straight upward march that occurred in July was a bear killer. Now, there is nothing wrong with being wrong, but for this go around my stubborn self decided to stay wrong for way too long. Needless to say, I'm still feeling some of the pain from that dark month. So what age old advice did I make myself re-learn this year?

1. Position size properly! By allocating too much capital into the call spreads, I set myself to lose too much money if stopped out. Don't let the allure of more riches dupe you into taking on an inordinate amount of risk.

2. Entering similar strategies on closely correlated securities is not diversification! I exacerbated my problem by not only entering call spreads on the RUT, but also the SPY. Two different securities-yes, but diversified? No! You see they pretty much move the same, so if I get pummeled on the RUT then.... you guessed it... I get pummeled on my SPY position.

If you're interested in sharing, what was your worst trade of 2009?

Next time I'll tackle my best trade of 2009.

Tuesday, December 29, 2009

Blast From the Past

As 2009 comes to a close and I review my trading and writing for the last year, I find myself rather pleased. This site has provided a creative outlet where I can share my market related thoughts and educate not only you all but myself. I've thoroughly enjoyed drumming up content day to day for you folks to mull over and wish to thank you for your readership and participation in the comments section. As we all prepare for the new year, I've compiled a list of the Top Ten Posts of 2009 based on unique page views.

In addition to today's Top Ten list, I also plan to construct a list of my top ten favorite posts for 2009.

Monday, December 28, 2009

IVolatility Trading Digest Blog

When I first started trading options, my source of choice for volatility charts was IVolatility. Though my first broker,OptionsXpress, offered volatility charts, they were too clunky and limited and as far as I'm aware, they still are. Not that I want to pooh pooh OptionsXpress, as they are one of the few brokers I'm aware of that even offers volatility charts. I currently do the lion's share of my trading at Interactive Brokers and as those of you that have ever traded with them probably know at this point, rather than focus on developing whiz bang tools (TOS anybody?), their forte is cheap commissions. Fortunately Livevol has recently come along and developed a pretty slick platform with quite a bit of versatility in viewing various volatility readings. So, needless to say, that's where I spend the bulk of my time when analyzing anything volatility related.

Now, on to the gist of today's post. Though I've drastically diminished the amount of time I spend on IVolatility's site, one feature I still review week to week is their blog, formally known as the IVolatility Trading Digest Blog.

From an educational standpoint, they do a pretty good job incorporating volatility analysis in the various strategies they highlight for their model portfolio. Though I don't recommend blindly following any one's recommendations, I do think it's useful to read through their rational for why they select one strategy over another. Over time IVolatility's blog has had some interesting educational write-ups worth exploring.

For related posts, check out:
Finding Volatility

Friday, December 25, 2009

Merry Christmas

Wednesday, December 23, 2009

Reflections on VXX

I received a question regarding VXX, the VIX ETN, and its inability to accurately track the CBOE Volatility Index (VIX). For reasons I'll expound on at the end of today's post, the few times I have traded the VXX was to the short side. Rather than trying to reinvent the wheel, I'm going to cite a few posts from Bill Luby, purveyor of VIX and More, and someone who knows way too much about volatility.

In his post VXX Calculations, VIX Futures, and Time Decay Bill reviews various factors that hinder VXX's ability to accurately track the VIX.
As I type this, the VIX is up about 6.5% for the day and VXX is only up about 2.0%. While it looks like today is a good day to be long volatility, getting 4/13 of the move in the VIX with a VIX ETN does not look like an efficient way to play the volatility trade. In fact, I have discussed the issue of what I call the VXX juice factor on a number of occasions and have concluded that on average, anyone owning VXX should not expect to capture more than 50% of the move in the VIX, at least based on data since the January 30th launch of VXX. Going forward, however, 40% might be a more realistic target. A reader asked about the extent to which VXX returns may be adversely impacted by time decay, rolling and other issues...
Click the post title for the remainder. The second post I'd recommend taking a look at is titled Why VXX Is Not a Good Short-Term or Long Term Play.
...Unfortunately, VXX has considerable shortcomings, both as a short-term and a long-term play. Investors who are long VXX hope that when volatility increases dramatically, they will benefit by holding the short-term VIX ETN. In fact, when the VIX spikes 10% or more in one day, VXX generally does not cover even half of that move in percentage terms. The table below shows the eight instances since the January launch of VXX in which the VIX rose 10% or more in one day. The results speak for themselves, but in the eight instances over the course of eight months, VXX has been cpaturing only one third to two thirds of the VIX spike. Ironically, when the VIX is flat or falls, VXX does a much better job of keeping pace...
Although buying VXX has by and large been an exercise of frustration for those seeking bullish exposure in the volatility space, it is fair to say shorting the VXX has been a veritable boon for those using it to gain bearish exposure. The negative roll yield occurring when VIX futures are in contango has been a definite advantage to those short the VXX. At the end of the day, there's nothing wrong with simply staying away from the VXX if you don't understand it. Matter of fact, that's probably sound advice for any complex or exotic trading products out there. If I were to play the VXX I'd lean towards fading rallies, particularly if VIX futures remain in contango.

It will be interesting to see if VXX behavior improves when we get into an environment of an extended VIX rise coupled with VIX futures in backwardation.

For related posts, readers can check out:

Mail Time- Index vs. ETF Options

Hi Tyler - do you prefer using index options versus the options on the ETF for the index? If so, why? What are the similarities and differences that one should be aware of when using index options? Thanks!

Thanks for the question Rene. The two biggest things you want be aware of when trading index options are the style of option and the details of settlement. Within the CBOE website you can view the product specifications of the various index options. I suggest spending some time on the site getting familiar with any index options you plan on trading.

Style of Option: Since the ETF's have underlying shares you can purchase, their options are typically American Style which means they be exercised any time prior to expiration. The majority of index options are European Style which means they can't be exercised early. This comes into play if you're shorting options that move in-the-money. With European Style options you have no risk of early assignment; with American Style options you do have risk of early assignment.

Settlement: American style options (including those on ETF's) are settled in stock, the European style options are typically settled in cash. So if I shorted a 500 call on a European style index and settlement price came in at 510, my short call would be $10 in-the-money. Consequently, the option seller (me) would have to pay out $1000 and the option owner would receive $1000.

The last trading day for most European style index options- including SPX, NDX, RUT- is on Thursday, one day prior to the 3rd Friday of the month. Settlement price is a theoretical price calculated based off of the market open on Friday. Settlement prices are posted on this CBOE website sometime following the open on expiration Friday.

As to whether one should trade index options or ETF's, such as the SPX vs. SPY, there are a couple things to consider.

Bid-Ask Spread: Sometimes index options have very wide bid-ask spreads ($2 or more) making it difficult to get a good fill. When playing the S&P, I've preferred using the SPY vs. SPX options. When trading the Russell 2000 however, I typically stick to RUT options as they usually have pretty tight bid-ask spreads- particularly the out-of-the-money options I deal with.

Commission: When trading ETF options, you usually have to purchase more contracts. For example a $10 vertical spread on the SPX would require $1000 of margin and consist of 2 contracts. The equivalent of the SPY would be 10 $1 vertical spreads and require 20 contracts. If you've got a high commission broker, it makes it a bit more difficult to make it worth your while with narrow spreads on ETF options. When I play with the SPY I typically do a $4 or $5 spread to cut down on the amount of commission.

There may be other factors, but these are probably the most obvious ones that I've seen. If I've missed any notable differences, pipe in within the comments section-

For a related post, check out:

Tuesday, December 22, 2009

Christmas Musings and a Trade Journal

Though Christmas is still a few days away and I'm still officially in "work" mode, it seems my mind has taken an early sabbatical. I find myself entirely uninspired on what subject matter I should cover in my next few posts. Some weeks it seems I could drum up content in my sleep, while others prove quite a bit more difficult. Tack on the fact that the markets are in snooze mode and you've got an environment that is rather unconducive to creative thought. One positive development we've seen over the past few weeks is a minor uptick in the amount of chatter in the comment section. As always, I encourage readers to post comments, thoughts, and questions in the comments section at the end of each post. On a side note, sometime before the end of year I plan on posting a recap of my top ten posts of 2009.

As for today's post, I'll offer up another trade journal you can mull over (click image to enlarge).

[Source: EduTrader]
December 14th
Trade Setup: Though small cap stocks exhibited relative weakness in the October to end of November time frame, we've since seen them exhibit relative strength in the midst of a range bound market. On December 14th, the Russell 2000 Index (RUT) broke out of an ascending triangle pattern. Based on upcoming holiday and quiet market, options remained overpriced, thus a sell.

Strategy: Sell a short term, OTM January 550-540 bull put spread.

Net Credit: $1.00
Max Reward: $1.00
Max Risk: $9.00
Probability of Profit: 1-.16 = 84%

Target: Close the spread @ $.20 or better (currently it's trading at $.35)
Trade Management: Close the spread if RUT breaks below support (570)

So far so good. Following the breakout, the RUT has continued to exhibit strength. This places the 550-540 put spread further out-of-the-money aiding in reaching the profit target quicker. Implied volatility (RVX) also continues to drop which helps to quicken the decline in value of the spread.

For related posts, check out:

Friday, December 18, 2009

The Oracle Calendar Part Deux

With ORCL's earnings announcement now in the rear view mirror and options expiration looming on the immediate horizon, let's take a look at how the ORCL calendar spread mentioned on Monday has played out over the week.

Trade Inception:
Buy (1) Jan 24 call for $.30
Sell (1) Dec 24 call for $.15
Net Debit = $.15
ORCL Closing price last Friday = $22.78

Remember the ideal scenario for a calendar spread is to have the underlying residing at the short option's strike price at expiration. Fortunately ORCL had a positive reaction to last night's earnings announcement and gapped up to $24 this morning - Bullseye!

Long (1) Jan 24 call @ $.80
Short (1) Dec 24 call @ $.30

[Source: EduTrader]

The trade could be closed now at $.50 or a 233% gain. If ORCL closes above $24 today, the short Dec 24 call would be assigned. Consequently, I would recommend closing the trade prior to the close to avoid assignment and lock in the gain. Those that are new to calendar spreads may be wondering, "hmmm.... calendar spreads can make 100+% returns in a week - Why not do them all the time?" Good point, why not? In my opinion there's one primary reason: Horizontal calendars have a relatively small profit zone, which means that you've got to very good at predicting where the stock is going to be around expiration. A feat easier said than done. This Oracle calendar had virtually everything go right, so before you jump feet first into a ton of other calendars, recognize ORCL was a home run you're not going to hit every time.

Thursday, December 17, 2009

Quick VIX Question

Could you explain why sometimes there are big differences between VIX cash and futures?

The VIX cash is a gauge of the expected volatility of the SPX over the next 30 days. So the cash will fluctuate day to day based on changes in option traders’ expectations of volatility in the near term. Currently the VIX is sitting at 21.75. If we break that down into expected daily moves, the S&P should realize a move of 1.37% or less roughly 68% of the time.

If you’re of the opinion the S&P will move a lot more than that, then you’d lean towards being a volatility buyer here. Conversely, if you believe the S&P will move much less than that, then you’d lean towards being a seller of volatility. VIX futures, on the other hand, are simply a snapshot of where the VIX is expected to be at a specific date in the future. Take the Feb VIX future currently trading at 26.70 for example. This simply tells us that the cash VIX is expected to be at 26.70 on February expiration. It says little about what the VIX is likely to do in between now and then.

VIX futures, particularly the longer dated ones, are often times not influenced at all by what’s going on in the cash VIX. Because the day to day moves in the cash are viewed as “noise” or short term aberrations, they are often ignored by longer dated futures. So don't be surprised if a big move in the cash VIX fails to even budge long term futures. Just remember the futures are pricing in any type of mean reversion expected to take place between now and then.

Wednesday, December 16, 2009

VIX Settlement

The settlement for December VIX options came in this morning at $20.84. As mentioned previously this information can be viewed on the CBOE Index Settlement Value page or via the ticker VRO:
[Source: CBOE]

[Source: EduTrader]

Of the two put purchases mentioned in last Thursday's post, the Dec 22.50 put had the highest percentage return. The Dec 24 put could have been purchased for $1.90 on Thursday and settled $3.16 in the money- roughly a 66% return. The Dec 22.50 put could have been purchased for $.70 and settled $1.66 in the money- roughly a 137% return.

Though I'm not an advocate of trading longer term VIX options, I do believe there are often short term opportunities arising with front month options close to expiration. Since front month futures converge with the cash VIX at expiration, they must begin to move more in tandem as expiration approaches. Consequently, there is a short term window where you can more efficiently game the direction of the cash VIX using front month options. The trades mentioned Thursday serve as a prime example.

Tuesday, December 15, 2009

Mail Time- Call vs. Put Spreads

When do you use a bull call spread vs. a bull put spread?

Before I divulge my personal preference, let's review the difference between the two. The bull call spread (sometimes referred to buying a call spread) involves simultaneously buying a lower strike call and selling a higher strike call option of the same expiration month. The bull put spread (sometimes referred to selling a put spread) involves simultaneously buying a lower strike put and selling a higher strike put option of the same expiration month. They both realize max profit if the stock resides above the higher strike price at expiration. We consider them equivalent or synthetic positions. In other words, the risk-reward characteristics should be virtually identical. Let's use the Russell 2000 index(RUT) to illustrate. With the RUT currently trading at 611, suppose we were considering entering either an in-the-money January 560-550 bull call spread or an out-of-the-money 560-550 bull put spread (click to enlarge).

[Source: EduTrader]
As you can see the risk graphs are virtually identical. Either the call spread can be bought for $9.00 debit or the put spread can be sold for $1.00 credit. I used the mid point of the bid and ask for each option.

Though they are identical on paper, the reality is most traders would prefer to trade the put spread in this scenario. Why? In my opinion the primary reason is the liquidity of out-of-the money puts versus in-the-money calls. Consider the open interest of the Jan 550 calls vs. puts: 302 vs. 11,472. A comparison akin to having Mini-me stand next to Shawn Bradley. The puts absolutely dwarf the calls (no pun intended). We can ascribe the drastic difference to the fact that you've got a lot more market participants interested in out of the money puts versus deep in the money calls. The open interest has a direct influence into the bid-ask spread. Currently the 550 calls are 64.40 by 65.60. The puts, on the other hand, are $3.50 by $3.70. Which would you rather try to navigate- the $.20 or $1.20 spread?

The other two issues often cited have to do with shorting in-the-money options vs. out-of-the money options. I'd venture to say most traders prefer trading out-of-the money options for two reasons: avoiding any early assignment issues and saving commission by allowing the option to expire worthless. I almost always close positions prior to expiration, so not sure the avoidance of commission applies for me. In addition, being assigned early on an in-the-money call spread results in realizing the max profit, so not sure that's necessarily a bad thing.

When using strike prices below the current price, I usually opt for using a put spread. On the other hand, when using strike prices above the current price, I usually opt for using a call spread.

For other related posts, check out:

Monday, December 14, 2009

The Oracle Calendar

In addition to options expiration, this week also ushers in a few earnings announcements from some big hitters including Best Buy, Research in Motion, and Oracle. During Friday night's Options Action, our option pundit pals highlighted a few spread trade ideas for each. Let's break down the calendar spread mentioned for ORCL.

Due to a neutral to mildly bullish outlook, as well as relatively pumped up front month options, the suggestion was to enter a slightly OTM call calendar spread. With ORCL closing around $22.80 on Friday, the Dec- Jan 24 call spread was used as an example.

ORCL Friday Closing Price- $22.78
Buy (1) Jan 24 call for $.30
Sell (1) Dec 24 call for $.15
Net Debit = $.15

As is usually the case heading into earnings, the front month options were trading at a much higher volatility level than second month. Currently the Dec 24 call option is at a lofty 48% and the Jan 24 call is at a mere 28%. Entering a calendar is one way to exploit the volatility skew in these front month options. Think of it this way- you're buying 5 weeks of time for $.30 (approximately $.06 per week), while selling 1 week of time for $.15. This is a reflection not only of the vol skew, but also the acceleration of time decay.

Take a look at the risk graph:

[Source: EduTrader]

Based on the risk graph, you can see the obvious best case scenario would be for ORCL to drift higher over the week and close on Friday just shy of $24.

Thursday, December 10, 2009

VIX Expiration on the Horizon

In addition to options expiration for equities and indices, next week also brings the laying to rest of December VIX options. Tuesday will be the last trading day with settlement occurring on Wednesday.

With a mere three trading days remaining until the final breath of life is snuffed out of the December cycle, might there be a few short term opportunities for those willing to stomach the high gamma/theta drama arising on the brink of expiration? Let's take a glimpse at the volatility landscape to see if we can build a case for an impending bullish or bearish move in the VIX over the coming days.

In recent weeks both 21 and 10 day historical volatility have taken a tumble to a "watching paint dry" level of 13%. As most no doubt already know, this is due to the resilient 25 point range that has developed in the SPX. The range is assuredly lauded by condor traders and premium sellers while being loathed by premium buyers and volatility seekers. Since realized volatility is seemingly on vacation, the VIX hasn't found much of a reason to muster up a sizable spike in some time (short of the Dubai hiccup). Sitting at its current level of 22.3%, almost 10 pts. higher than historical volatility, one would think that a move higher in the VIX is unlikely, particularly if the SPX continues channel surfing.

On the futures front, with the December VIX futures closing at 22.50 (a .20 premium), they have virtually caught up to the cash... or should I say cash caught up to the futures? Suppose we think the VIX is sideways to down into Dec expiration. How's about simply buying a put option? Here are the current values of the three closest December puts as of yesterday's close:

VIX 24 put $1.90
VIX 22.50 put $.70
VIX 21 put $.15

I'm never a fan of buying short term, OTM options so I'd focus on buying either the 22.50 or 24 strike. Since the 24 put is currently $1.40 ITM, it has $.50 of extrinsic value and an expiration break even at $22.10 or lower. Due to the 22.50 put currently residing ATM, it's $.70 of premium consists solely of extrinsic value and its expiration break even is $21.80.

If you were of the opinion that the VIX lifts into expiration, shorting the 22.50 puts is probably the play, though I think the wind is in your face this go around.

Tuesday, December 8, 2009

Credit Spread Entry Musings

When entering directional credit spreads (a single put or call spread, not a condor), which is more important- time to expiration or the chart pattern dictating your timing? Let's say you prefer to enter credit spreads approximately six weeks prior to expiration. What do you do when you find a nice bearish setup such as a down trending stock that has rallied up to resistance, but you're seven weeks to expiration. Do you enter now to exploit the imminent drop in price suggested by the chart or do you wait a week to get a higher theta?

Per the time decay curve displayed below, theta increases exponentially as expiration approaches.

Those that rely primarily on time decay usually focus on entering trades during a certain window of time such as 4 or 6 weeks prior to expiration. While this simple approach may work for delta neutral trades such as condors, I would argue it's too simplistic when it comes to directional trades. With directional trades, stock price movement (delta) is more important than time decay, especially when we're talking 6 to 7 weeks from expiration. In addition, it's not as if you're not compensated for selling a credit spread 7 weeks out instead of 6. Remember, there's going to be more extrinsic value built into option prices with more time remaining to expiration. Which means that a trader receives more credit when selling a spread seven weeks out vs. six (assuming volatility remains constant). As a result, I'm never really worried if I sell a credit spread outside of the "optimum time frame", as long as I'm receiving sufficient premium and have a solid setup.

By waiting a week, you also run the risk that the underlying drops significantly. Though you can relish in the thought that you have a higher theta, there will be much less credit available in the spread you considered selling. It's not a bad idea to have a "optimum time frame" when selling credit spreads, just don't be afraid of using some discretion in going outside of the time frame if you're presented with what you deem to be a great opportunity.

For related posts, check out:

Saturday, December 5, 2009

Options Action- GLD Collar

Gold was in the spotlight during Friday night's Options Action. For those currently long GLD stock and fretting over a continued sell-off from Friday's ugly price action, entering a zero cost collar was suggested. Basically the zero cost collar offers downside protection while limiting upside profit potential. Let's break it down.

Existing Position: Long 100 shares of GLD at $100 entry price
New Positions: Sell the Jan 120 call option for $1.75, Buy the 108 put option for $1.75
Long Stock
[Source: EduTrader]

The collar consists of simultaneously selling an OTM call option and buying an OTM put option. It can be thought of as selling a covered call and buying a protective put. The put option locks in the right to sell the stock at the strike price, thereby limiting the downside risk. The call option obligates you to sell the stock at the strike price, thereby limiting the upside profit potential.

The premium received from selling the call option helps to finance the purchase of the downside put. If you sell the call for enough premium to purchase the put, it is often referred to as a zero cost collar. The example used during Options Action was a good example. The $1.75 received from selling the Jan 120 call was enough to pay for the Jan 108 put option.

Collar trades can be a legitimate way of adjusting an existing profitable long stock position. As a prerequisite you would need to be willing to cap your upside in exchange for limiting downside. As far as timing goes, I would considering entering collars if I was anticipating unstable markets or a looming sell-off in my individual stock. In hindsight, last Thursday would have been the ideal time to enter on the GLD as it would have given some protection for Friday's downdraft.

For other related Options Action posts, check out:

Thursday, December 3, 2009

What Ever Happened to Those Trade Journals...

When I originally crafted the idea to offer up occasional trade journal posts, my intent was to do so every few weeks. Well, every few weeks has turned into every few months, as these posts have received relatively scant attention from myself. Since today's trading day has been like watching paint dry and I find myself rather uninspired to delve into new subject matter, why not resurrect the trade journal angle and review a recent completed trade (click image to enlarge).

[Source: EduTrader]
Nov 11th
Trade Setup: After forming a double top and breaking below the 50 day moving average, RUT proceeded to rally back up to the underside of the 50 MA and intermediate trend line. Due to these bearish signals I was of the opinion that RUT would not break above its highs around 625.
Strategy: Sell a short term, OTM December 640-650 call spread.

Net Credit: $1.00
Max Reward: $1.00
Max Risk: $9.00
Probability of Profit: 1-.15 = 85%

Target: Close the spread at $.20 or better.
Trade Management: Close the spread if RUT breaks above resistance (625).
Did I plan my trade and trade my plan? yes!

In hindsight I could have waited until the 16th and sold the call spread for about $.50 more (1.50), however I had a pretty solid bearish setup when I entered so I'm satisfied with the outcome. If you're of the opinion that small cap stocks continue to underperform, the recent four day rally we've experienced could be looked at as another opportunity to sell call spreads.

For other related posts, check out:

Tuesday, December 1, 2009

Mail Time- RIMM Strangle

Hi Tyler,

Looking at RIMM what strangle play would you consider the most. I do believe it will either have a great gain or go down big time over the next year. Any opinions would be appreciated.

Thanks, Adam

Before I delve directly into RIMM, let's recap the strangle strategy to make sure we're all on the same page. The strangle involves the simultaneous purchase of an OTM call and OTM put with the same expiration month. It is essentially a bi-directional, long volatility strategy which profits from either a large move up or down in the underlying stock or an increase in implied volatility. Consequently, I would only consider purchasing strangles if I believe one of the following two things (or both).

1. The underlying stock is poised for a large move in either direction
2. Options are relatively cheap (implied volatility is low)

Personally I'm not a huge fan of buying straddles or strangles except in rare circumstances. Now, on to the question at hand- Strangles on RIMM. Based on the question, we already know that Adam believes the stock is poised for a large move so that takes care of criteria number one. What about implied volatility? Are RIMM options cheap or expensive right now?
[Source: Livevol Pro]

Current implied volatility is at 55% with 20 day HV at 46% and 10 day HV at 23%. So I wouldn't say that options are cheap at this point by any means. In hindsight the ideal time to enter the straddle would have been around October 20th, when IV was around 34%. RIMM has earnings on December 17th, so we're seeing a rise in volatility and will probably continue to see it elevated in anticipation of the event. Bottom line- criteria number two probably isn't met at this point, in my opinion.

In placing the strangle we have two primary considerations: which month and strike price? Choosing strikes is probably the easier of the two questions for me. I'd keep it simple and buy one strike out of the money either way(65 call, 55 put). In the question the opinion was that RIMM will move big over the next year. One of the big issues that arises with placing a one year strangle is cost. With RIMM trading at $60, the Jan 2011 55-65 strangle is trading around $20 or roughly 1/3 the price of the stock. That's an expensive pill to swallow. If you wanted to cheapen it up you could opt to buy less time. Which month you end up choosing is a matter of personal preference. It's tough to make the case that one month is "better" than another as there are trade offs to buying longer vs. shorter term options.

For related posts, readers are encouraged to check out:

Dark Side of Dubai

I came across this article the other day. Very very interesting read shedding insight on the sorry plight of many in Dubai. Click here to access the entire article.

Relative Performance: Eyeball It

One of the simplest methods available for executing relative performance is eyeballing it. This process simply involves assessing the two charts you're interested in comparing to determine which is stronger. Remember, the primary cornerstone of technical analysis is that market action discounts everything. In essence, any and every factor that could influence a stock's price is already reflected in the price. If you subscribe to that notion then your trading decisions are probably based off of a stock chart as opposed to other extraneous factors such as news, fundamentals, etc...

So rather than using a relative performance chart as I did in the last post regarding this discussion, let's simply compare the chart of SPY to IWM in an effort to determine which one is exhibiting relative weakness. Though some traders may use secondary indicators such as the MACD or Stochastic, I prefer to get right to the heart of the matter by focusing on price and price alone. Something as simple as comparing the last three pivot highs will suffice (click image to enlarge).

[Source: EduTrader]

Over the past few months the SPY (left chart) has been able to form three consecutive higher pivot highs. The IWM (right chart), on the other hand, formed an equal pivot high followed by a lower pivot high. It takes all of one second to determine IWM is exhibiting relative weakness. Whether they know it or not, most traders intuitively consider relative performance as they're scrolling from chart to chart. Let's try another: SPY vs. DIA
[Source: EduTrader]

Notice how they have both formed three consecutive higher pivot highs. Rather than taking this at face value and assuming they're both equally strong, we could assess the distance between the pivots to determine which trend is exhibiting more momentum. As you can see the DIA moved a lot further on its most recent upswing. Thus, it's fair to say DIA is exhibiting relative strength vs. SPY.

For related posts, readers are encouraged to check out:

Sunday, November 29, 2009

Gaming the Gold Bugs Redux

The recent meteoric rise in GLD has ushered in yet another volatility surge, which is just one more example of the positive correlation we tend to see with GLD and implied volatility. As mentioned in Gaming the Gold Bugs, these spikes are usually short lived and experience reversion to the mean once the mad dash for options subsides. Tack on the fact that IV30 is sitting at a hefty premium to 20HV (24% vs. 15%) and it's fair to say volatility sellers have a bit more edge at this point versus buyers.

So last time I mentioned using a 1x2 call spread to exploit the elevated implied volatility as well as place a mildly bearish bet. What about this go around? The big x-factor with current conditions is the fact that GLD has gone virtually parabolic, making it quite difficult to step in and fade the move. Since the 1x2 call spread involves selling naked calls, there can be considerable risk if the underlying rises too far. Though I was comfortable selling naked calls last go around, I'd be lying if I didn't admit the parabolic rise in GLD gives me pause.

To paint a better picture, think of it this way. Flip the chart of GLD upside down and pretend it just dropped about 15-20 days in a row- a veritable falling knife. Would you be comfortable selling some naked puts? If the huge drop in price gives you a bit of pause, then you understand where I'm coming from.

With that being said, let's explore a 1x2 call spread just for kicks. Suppose we buy the Dec 119 call and sell two 121 calls for a net credit of $.25. Consider the risk graphs:
[Source: EduTrader]
If we wanted to make more of a bearish bet, we could potentially use lower strikes (such as 117-119), sell additional naked upside calls, or simply settle with bear call spread.

Friday, November 27, 2009

Chinks in Small Cap Armor

As mentioned previously, there are a few different tools at our disposal when executing relative performance analysis. The first tool I'd like to hone in on is a relative comparison chart. Though this analytical tool can undoubtedly be found in various places on the web, I personally use the one provided on Yahoo! Finance. To access the tool, go to, type in the ticker symbol you want to view in the "get quotes" box, and hit enter. Once it pulls up the information for that security, click on "Interactive" under the Charts section on the left side of the window. Within the chart displayed you can select "compare" and add other securities that you want to use in the comparison.

Within the chart you can compare virtually any time frame, from as short as one day to as long as about 10 years. Consequently, one must necessarily decide the optimal time frame to use for the comparison. Though opinions may vary from trader to trader, choosing the ideal time frame for me comes down to what type of trade you're considering. If you're looking for a day trade candidate, you may the stock's performance over the last day or week. If searching for a swing or position trade, consider the last few weeks to months. Remember there does tend to be a certain degree of "noise" on a day to day basis, so be careful with putting too much emphasis on any one day's performance. The relative strength or weakness of a certain stock or sector becomes more apparent over longer comparison periods.

One of the divergences we've seen in recent weeks has been the relative weakness exhibited by small cap stocks. Consider the following 3 month comparison chart between the IWM and SPY (click image to enlarge).

[Source: Yahoo! Finance]

While the IWM (small cap) was moving in lock step with the SPY (large cap) between Sept. and October 19th, small cap stocks sold off much more aggressively between Oct. 19 and Nov 2nd. Though the SPY has since rallied to new highs, the IWM has failed to even reach its 2009 highs. While large cap stocks were able to stage a strong advance (roughly 7%) in the last 3 months, small cap stocks have struggled to post a measly 2% gain.

Given the recent lackluster performance of the little guys, it's fair to say the bears may be gaining the upper hand in small cap land.

Wednesday, November 25, 2009

Mail Time- Credit Spreads

Let's take a breather from the relative performance discussion and tackle some viewer mail. NGBSTL posed the following question in response to my introduction post, A Primer on Relative Performance.

I enjoy credit spreads b/c my view is they are one of a few ways you can profit from 2 outta the only 3 possible behaviors of underlying (up,down,sideways): so it can either go away from you or slosh around where it is, and you profit in both those instances. My criteria for finding ideal candidates this far has been limited to seeking some sort of technical line of defense between short strike & current price. But I'd love to learn more 'sophisticated' criteria for finding such candidates...maybe a future post? thx!


Thanks for the comments and question. The higher probability of profit inherent with selling out-of-the money credit spreads is certainly one of the advantages to using them. The idea of winning the majority of the time is an alluring prospect for traders that hear of this type of strategy (whether it be selling call spreads, put spreads or both). As with most strategies where those on one side of the trade win the majority of the time, we must keep in mind that the occasional losers can easily dwarf the winners. Your success with selling credit spreads isn't so much dependent on how you manage the winning trades, but rather the losing ones. So, I would hope that you have some type of rules in place helping you to minimize losses on credit spreads that go awry.

In terms of finding candidates, I've seen a few different approaches. For directional trades (selling call or put spreads individually), I simply use technical analysis. If I have a strong up trending stock, I'll look to sell put spreads on the dips. For bearish candidates I'm looking for down trending stocks that have rallied to resistance. Bottom line is I have to see some type of bullish or bearish price pattern before I pull the trigger. Implied volatility also plays a part. Ideally I like to be entering when implied volatility is too high and see it diminish throughout the duration of the trade.

The other approach commonly used for Iron Condors, though it could be used for directional trades as well, is simply using the same underlying month to month. You'd obviously want to choose an underlying that has liquid options with tight bid/ask spreads. A good example could be the SPY or RUT. Those that use this approach tend to focus on indexes or ETF's thereby avoiding earnings announcements and other potential company news events that could disrupt the normal ebb and flow of price action.

Here's an example of my two most recent directional credit spreads. The graphics pretty much speak for themselves.

[Source: EduTrader]

Tuesday, November 24, 2009

Comparing Apples to What?

In continuing with the groundwork laid in yesterday's introduction of relative performance, I want to highlight various methods I've used to determine the relative strength of two securities. Suppose I'm considering a trade on an individual company such as Apple Inc. (AAPL). The first consideration is deciding what to compare it to. The three most common comparisons are as follows: Stock to Market Index, Stock to Sector, Stock to Stock. Let's expand on each one.

Stock to Market Index

Since the majority of traders use the S&P 500 Index as the benchmark for market performance, it makes sense to compare the SPX to AAPL to ascertain whether AAPL is outperforming (exhibiting rel. strength) or under performing (exhibiting rel. weakness). The ideal bullish scenario would be AAPL outperforming the SPX. If you preferred to use the Dow Jones Industrial Average or Nasdaq Composite, you could obviously modify which market index you use.

Stock to Sector

Just as I'd like to see AAPL outperforming the SPX, I'd also prefer that it was outperforming the technology sector. If you're unaware of how to chart a sector, you can use the Select Sector SPDRs which can be found on To borrow a commonly cited phrase from an obnoxious market pundit, I'm seeking the "best of breed". Not necessarily from a fundamental perspective, but rather from a relative performance perspective. If AAPL is indeed outperforming its sector than one would think it has a better chance of continuing to increase in value vs. if it were under performing its sector.

Stock to Stock

I've seen two approaches used in choosing which stock to use in the comparison. The first approach is to pick one of the stock's competitors within the same sector. The other approach would be to simply choose another stock you're considering buying in an attempt to identify which one is relatively stronger. In the case of AAPL, perhaps I could use GOOG if I wanted to choose one in the same sector. If, on the other hand, I was also considering a bullish trade on Exxon Mobil Corp. (XOM), there's nothing to say I couldn't use it in comparison to AAPL.

Whether we use one or all of the aforementioned comparisons, the bottom line is we're trying to build a bullish (or bearish) case on the stock in consideration for a directional trade. If AAPL is exhibiting relative strength vs. the broader market, the tech sector, and other competitors, we've got a much stronger thesis for selling put spreads or entering some other type of bullish trade.

Next time we'll explore the various tools/indicators that can be used to actually perform the analysis.

Monday, November 23, 2009

A Primer on Relative Performance

Though I tend to favor delta neutral positions such as iron condors, I still have a smattering of somewhat directional positions within my portfolio. What do I mean by 'somewhat directional'? Well, rather than placing an aggressive position such as long calls or puts, which can be both quite lucrative when right, but quick to punish when wrong, I usually opt to sell out-of-the-money credit spreads. Obviously when I sell a call or put spread I'm making a directional bet, but much less so than if I were to buy calls or puts outright. One of the tools I use to aid in choosing which underlying I want to use for these types of trades is relative strength.

Though the relative performance of two securities can be measured over any time frame, I tend to favor longer term. The rationale being that day to day we often see minor aberrations in price that are nothing more than noise. No sense making a mountain out of a mole hill. It's when relative strength continues over weeks to months that I begin to take notice. From a relative performance standpoint, what can we surmise about the following 2 securities?

ABC has increased 5% over the last two weeks.
XYZ has increased 2% over the last two weeks.

We could say any of the following: ABC is outperforming XYZ. ABC is exhibiting relative strength. XYZ is underperforming ABC. XYZ is exhibiting relative weakness.

If you subscribe to the notion that strength begets strength and weakness begets weakness, then naturally you would look for bullish trades on ABC or bearish trades on XYZ. In other words, when bullish we seek relative strength and shun relative weakness. When bearish we seek relative weakness and shun relative strength. Next time we'll explore a few different methods used to perform this type of analysis.

Friday, November 20, 2009

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.

Wednesday, November 18, 2009

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 volatility that, I'll see if I can mix things up a bit going forward.

Tuesday, November 17, 2009

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!

Monday, November 16, 2009

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:

Thursday, November 12, 2009

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: