Tuesday, June 30, 2009

Vega Part I

So far in our Greeks overview we’ve tackled Delta, Theta, and Gamma. Since I’ve highlighted volatility with increasing frequency over recent posts, I figure it’s high time to give an in depth overview of Vega. Though Vega is not a Greek letter, it is one of the greek variables commonly used to measure option risk. Specifically, Vega measures an option’s sensitivity to a one point change in implied volatility. Let’s kick off our conversation with a primer on implied volatility.

Implied Volatility

There are two definitions I like to use when explaining implied volatility. First, it is the expectation of future volatility. The options board is perpetually trying to accurately price in the volatility the underlying stock will exhibit in the future. If the underlying stock’s realized volatility is expected to increase, you’ll see implied volatility rise. Conversely, if the stock’s realized volatility is expected to diminish, implied volatility will fall. Although the options market is usually efficient and does a pretty good job accurately predicting future volatility, there are obviously times when it gets it wrong. Trading volatility is primarily about exploiting opportunities that arise when options seem to be underpricing (in which case I’d be a buyer of volatility via strategies such as straddles or strangles), or overpricing (in which case I’d be a seller of volatility via strategies such as short strangles or condors) future realized volatility.

Implied volatility is derived from option prices. When plugged into a theoretical option pricing model, such as Black-Scholes, it makes the theoretical option price equal to the current option price. In other words, implied volatility is the level of volatility the underlying stock must exhibit or realize between now and expiration to justify current option premiums. If in that time frame the underlying stock exhibits less volatility than was originally implied, the option was theoretically overpriced. Conversely, if the stock exhibits or realizes more volatility than originally implied, the option was theoretically underpriced.

For example, the VIX (implied volatility for 30 day SPX options) currently resides around 26%. If over the next 30 days the SPX realizes 10% volatility, current SPX options are severely overpriced. Conversely, if the SPX realizes 40% volatility, current options are severely underpriced. As you can imagine if the SPX realizes 26% over the next 30 days then current options are fairly priced, meaning volatility buyers or sellers don’t really have much of an edge.

Volatility is easiest understood when thought about in extremes, so let’s explore two scenarios on either end of the volatility spectrum.

Scenario #1- Low (or no) Implied Volatility

Suppose stock XYZ closed its trading session around $40 a share. That night news hit the wires that one of XYZ’s key competitors, ABC, had submitted an offer to buy XYZ’s company at $60 a share. The next day, XYZ stock gaps up to $56 shares and it begins to drift higher toward $60. Throughout the week, the buyout gets approved by XYZ’s board and is therefore all but a done deal. The stock begins to trade in a relatively tight range around $60 as market participants realize it isn’t worth any more or less than $60. Because the stock is getting bought out at $60, the expectation of future volatility(e.g. implied volatility) is essentially 0%. A glance at the options board will probably show all OTM options, short term as well as long term, trading around $0 as no one is willing to bid up option premiums because they know the stock isn't going anywhere.

Scenario #2- High Implied Volatility

Biotech stock CRZY closed the day’s trading session around $40 a share. That night news came out that CRZY just initiated clinical trials on a drug with the potential to cure cancer. Because the potential revenues from sales of such a drug are so enormous, CRZY opens at $50 the next day. As speculation runs rampant, option traders begin to aggressively buy up OTM options looking to profit from the potential run up in price. This huge demand and subsequent increase in option premiums drives up implied volatility to 300%. Unlike scenario #1, the expectation of the stocks future volatility is huge. As such, option traders are more than willing to pay higher prices for options because they expect to be justly compensated by a large move in the underlying stock.

For more information on volatility I would highly recommend taking a stroll over to VIX AND MORE, which contains an extensive repository of info. The blog’s author, Bill Luby, possesses a knack for demystifying the more esoteric nuances of volatility.

Next time we’ll delve into the intricacies of Vega.

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Sunday, June 28, 2009

APOL Earnings

Although Alcoa's earnings is set to kick off the "official" earnings season next Tuesday July 7th, we still have a few announcements trickling in pre-Alcoa. Besides RIMM's earnings last week, the pre-Alcoa earnings calendar seems to be bereft of any big hitters. On the docket tonight Apollo Group (APOL) seems to be the only one worth mentioning. Matter of fact, APOL received some face time on Friday night's Options Action where they compared a short strangle vs. an iron condor play going into APOL earnings. APOL realized volatility has been languishing over the past few weeks as 30 day HV sits at 39% and 10 day HV at 37%. The pre- earnings options bid up has driven IV up to 55%.
As mentioned in Off the RIMM, options typically get a pre-earnings bidup that causes them to trade at a significant premium to HV. Once again the 64K question is whether or not the options are overpricing or underpricing the uptick in realized vol that is bound to come due to the post earnings gap. Assuming a trader is wanting to fade the increased implied volatility (e.g. short volatility) into the earnings, let's explore two possible strategies.

Short Strangle
APOL currently sits around $66.75, so we could construct a July strangle by shorting the July 60 put and 75 call.
Sell July 60 put @ $1.05
Sell July 75 call @ $1.10
Net Credit = $2.25
Upper Breakeven = $77.25
Lower Breakeven = $57.75

Shorting a Strangle is one of the purest ways to place a short volatility bet. The theoretical unlimited risk can be a tough pill to swallow for most traders. However, it can be partially mitigated through proper money and trade management (e.g. don't bet the farm on this type of trade!)
A more conservative approach may consist of playing condors instead.

Iron Condor
Sell July 60-55 put spread @ $.77
Sell July 75-80 call spread @ .65
Net Credit = $142
Upper Breakeven = $76.42
Lower Breakeven= $58.58

The obvious allure of the Iron Condor is its inherent limited risk. However, it does require giving up about $.80 of the credit you would have received from the short strangle, plus paying two extra commissions on the long call & put. Whether or not it's worth the extra cost to limit the risk is up to you.
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Friday, June 26, 2009

Gaming Time & Volatility

As we continue our exploration of delta hedging, I feel it appropriate to once again highlight the difference between the simple world of stocks and the complex world of options. If you missed the most recent post on delta, you can view it here. Within the stock market a traders choices are severely limited to one of two actions: buying or selling short. On the other hand, the options market includes four different actions: buy calls, sell short calls, buy puts, and sell short puts. Moreover, one can combine the aforementioned actions in virtually limitless combinations to establish a myriad of strategies with varying risk-reward characteristics. From a na├»ve point of view, it may seem as if it is easier to trade stocks because of the few choices available. I’d actually take the other side of the argument and say that the options market is easier.

The beauty of the options market is it affords us the ability to profit from variables that can quite often be easier to predict that stock direction. Consider which of the 3 primary variables (stock price, time, volatility) that influence an options price is easiest to predict.

Time obviously tops the list because it is a no brainer. As it’s the one sure thing within the options market, I prefer to have it on my side and rarely find myself placing negative theta trades. I find when my portfolio is net positive theta (which it always is), it serves as a positive psychological booster in the way I view the market. With a positive theta portfolio, my money is theoretically working for me every single day. Furthermore, I don’t feel forced to place trades every day in an effort to profit, as my existing trades should be theoretically making money due to time decay.

After time, volatility is the second easiest variable to predict. The key characteristic of volatility that aids in predicting its future direction is mean-reversion. The obvious trick to mean-reversion is knowing what the “mean” is (it unfortunately varies as market conditions change). Using the VIX as our example, there have been periods of time such as between Aug 2007 and Sep 2008 where the VIX traded in a rather predictable range. It consistently reverted back to its mean every time it got too overbought or oversold. In addition to comparing the VIX to its historical range we could use various methods such as comparing current IV levels to historical volatility or future volatility expectations.

If I want to focus on profiting solely from time decay (condors or calendars) or speculating on future direction of volatility (straddles/strangles, condors), it necessitates hedging off the unwanted risk of an adverse move in the underlying stock. In other words, at some point I may want to delta hedge my position and focus on profiting from the two more predictable variables (time & volatility).

For example, although an iron condor is generally delta neutral at trade inception, if the underlying stock price were to rise in value, my condor position would become increasingly delta negative. Conversely, if the underlying were to fall in price, my condor position would become increasingly delta positive. At some point when the position delta exceeds my comfort zone, I will probably want to hedge off the delta risk.


Thursday, June 25, 2009

VIX Smack Down


Hear that?

It's the extrinsic value getting sucked out of option premiums.

With today's rally from nowhere, the VIX has been taking it on the chin. Intraday the VIX moved sub 27. Keep in mind the VIX hasn't had a daily close below 28 since back in September of last year. It will be interesting to see how the VIX closes the day.

For those doubting Thomas's out there unable to curb the inner contrarian, selling OTM puts on the VIX may serve as a decent bullish bet on volatility.

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Wednesday, June 24, 2009

What to do, what to do...

The markets had a nice pop before the 2:15 PM EST Fed Announcement. From a charting perspective we've rallied back up towards the upper trendline of the 30 min. downtrend we're in the midst of. The last 2 times we're rallied to resistance have been opportunities to load up on bearish trades. Time to load up again or wait for the Fed announcement? The announcement is always an X factor, as it's impossible to predict the knee jerk reaction.

I suppose one could compromise by entering part of the position now, then wait for the Fed before loading up on the rest...

Tuesday, June 23, 2009

Variable Delta and Risk Graphs

I kicked off my series on delta hedging by exploring the intricacies of delta and risk graphs. If you missed it, you can find it here. In the first installment we explored the difference between fixed and variable delta, focusing on how the former plays out on a risk graph. Today we'll focus on the latter.

There are 2 types of Delta: Fixed and Variable
Stocks have fixed delta, Options have variable delta

Remember, delta ranges between 0 and 100.

ITM options have delta >50
ATM options have delta = 50
OTM options have delta <50

Variable Delta: If I were to buy an at-the-money call option, my position delta would be around +50. This means if the underlying stock were to increase $1, my call option would increase $50. As the call moves in-the-money, the delta increases; as the call moves out-of-the-money, the delta decreases. Thus we could say that variable delta is in a constant state of flux. For option positions the delta fluctuates as the underlying stock price changes.

What's it look like on a risk graph?
Long ATM call option

What can we glean from the risk graph?
1.Whereas a fixed delta risk graph is a straight line, a variable delta risk graph curves (this is why gamma is often called the curvature of an option).
2. When the call is ATM, it's delta = 50. As it moves ITM the delta approaches +100, and as it moves OTM the delta approaches 0. Notice the effect that these delta changes have on the slope of the line.
2. The long call risk graph changes closer to a 45 degree line (sloping from bottom left to top right) as delta approaches +100, and changes closer to a horizontal line as delta approaches "0". Put another way, the steeper the line, the higher the position delta; the flatter the line, the lower the position delta. Understanding this becomes important when looking at more complex option trades.
Long ATM put option
What can we glean from the risk graph?
1. A put options delta is variable as well, thus its risk graph curves.
2. When the put is ATM, it's delta = -50. As it moves ITM the delta approaches -100, and as it moves OTM the delta approaches 0. Notice the effect that these delta changes have on the slope of the line.
2. The long put risk graph changes closer to a 45 degree line (sloping from bottom right to top left) as delta approaches -100, and changes closer to a horizontal line as delta approaches 0.

Long Straddle Position
What can we glean from the risk graph?

1. The straddle starts off delta neutral (the risk graph is horizontal in the middle)
2. When the straddle is ATM, it's delta = 0. As the stock price increases (calls move ITM, puts move OTM) the position delta approaches +100, and as the stock price decreases (calls move OTM, puts move ITM) the position delta approaches -100. Notice the effect that these delta changes have on the slope of the line.
2. A rise in the stock price causes the risk graph to change closer to an upward sloping 45 degree line (bottom left to top right). Conversely a fall in the stock price causes the risk graph to change closer to an upward sloping 45 degree line (bottom right to top left).

The fact that options possess variable delta results in a certain degree of complexity when trying to delta hedge. Because delta is in a constant state of flux it requires constant monitoring and adjusting when trying to keep a position delta neutral (or close to).

Now that we're all squared away on variable & fixed delta we can start to delve into delta hedging various option strategies.

On a related note, Condor Options had a very nice post today on Why Delta Hedging Matters. Take a look if you haven't seen it, as it sheds some insight on delta hedging.

Stay tuned...


Trade Journal- RUT Bear Call

As mentioned in my original Trade Journals post, I will begin posting trade recaps every week or so of various trade strategies I use. My primary purpose is provide you with a glimpse into my rationale for choosing strategies as well as timing my entry. I've often receive questions pertaining to my thought process for certain trades, so these posts will allow me to elaborate.

With the market weakness we've experienced this past week, I wanted to highlight a July bear call spread on the Russell 2000 Index (RUT) I placed on July 16th.

June 16th:
TRADE SETUP: After exhibiting slowing momentum and basing sideways, the RUT finally broke below support of the base. After breaking support(517 area) on Monday (15th), it experienced an intraday bounce back up towards resistance on Tuesday morning. I used the intraday bounce as an opportunity to enter OTM bear call spreads.
STRATEGY: Sell a short term, OTM July 570-580 Bear Call Spreads for $1.00

Net Credit = $1.00
Max Reward = $100
Max Risk = $900
Probability of Profit = 1 - .15 = 85%

TARGET:Buyback call spreads @ $.20 or better
TRADE MANAGEMENT: Close trade if RUT breaks above resistance (535)
Did I plan my trade & trade my plan? - Yes
Did I maximize my gains & Minimize my loss (to a reasonable extent)? - Yes- Closed position when hit profit target


Monday, June 22, 2009

Volatility Crush

Let's finish up the whole RIMM earnings saga by posting a before and after of implied volatility. As previously discussed, option premiums get bid up in anticipation of the earnings announcement, causing a lift in implied volatility. As traders are purchasing calls or puts, they willingly bid up or pay more for these options as they *know* the stock will gap one way or another in reaction to the earnings announcement. Thus, they hope they will be compensated for paying up for these options by a large favorable gap in the underlying. In the first picture below you can see RIMM options IV was sitting around 72% pre- announcement.

After the announcement and subsequent gap in stock price, option owners generally begin to unload their options, hopefully at a profit, but most often I would bet at a loss. As all of this supply begins to be absorbed into the options market, generally IV will plummet from its pre-earnings lofty levels. The picture below depicts the post announcement IV crash in RIMM to around 50%.
You'll see this dynamic play out time and time again with earnings announcement- so if you decide to play options around earnings, make sure you take into consideration the typical changes in volatility that occur.


Saturday, June 20, 2009

RIMM Follow Up

Thursday's post highlighted a few potential earnings plays for RIMM earnings. Let's see how they would have played out.

On Thursday RIMM closed @ $76.55. The initial knee jerk reaction to RIMM earnings announcement was a quick selloff in the after hours market towards around $72, following which it traded back up towards $76 where it opened on Friday. All in all, the reaction to the announcement caused RIMM to gap down a measly $.60 ($76.55 - $75.95) between Thursday's close and Friday's open. Quite an underwhelming reaction to say the least! The obvious winner would have been short volatility strategies such as the 65-70-85-90 iron condor we mentioned. Although the condor was trading at $1.70 credit on Thursday, on Friday the call & put spread could have closed out for around $.02 or $.03 apiece. I would have most definately closed the spread immediately at the opening to lock in almost 100% of the potential reward. Holding until the end of day to eke out the last few pennies of gain would not have been wise as RIMM could have traded down below $70.

The obvious loser would have been the straddle purchase. The straddle needed RIMM to gap at least 10% just to breakeven. Even had you held the straddle until the end of day, with RIMM closing at $72.76, the 75-80 strangle would have only been worth $2.24 at expiration. Since it was purchased for $5.75, it would have suffered a 61% loss.

RIMM's rise in IV and ensuing IV crush following earnings serves as a prime example of how the options market anticipates and reacts to the gap that typically follows every companies earnings announcement. The trick to playing earnings is to consistently gauge whether or not options are overpricing or underpricing the increase in the underlying stocks volatility. A feat easier said than done!

This go around RIMM's reaction was no doubt applauded by volatility sellers while being cursed by volatility buyers.


Thursday, June 18, 2009

Off the RIMM

We got RIMM earnings on deck tonight, so let's take a look at current volatility levels and see what the options board is pricing in. It's always interesting to see a company report earnings the day before options expiration, as the front month options (with 1 day left to expiration) give us a clear glimpse into how much the stock is expected to gap after the earnings announcement. It also provides some interesting 1 day option plays for those that have a strong bias as to whether or not implied volatility is cheap or expensive.

RIMM's historical volatility has dropped significantly over the last few months, which is altogether not surprising given the overall market has quieted down drastically. RIMM's 30 day HV currently sits at 44%, while 10 day HV is sitting at 35%. In anticipation of tonight's earnings announcement, RIMM's Implied volatility has risen to 72%- an obvious premium to current levels of realized volatility.

The $64K question is whether or not IV is too high or too low. Are the options overpricing the gap RIMM will experience tomorrow or underpricing it?

RIMM is currently trading at $76.75. We can look at a June strangle to get a read on how big of a move RIMM needs to make for the options to be fairly priced. The 75-80 June strangle (long 75 put, long 80 call) currently costs $5.75. Those buying the strangle are betting that RIMM will gap up to at least $85.75 or gap down to at least $69.25. That's an 11% upside move and a 10% downside move. Take a look at the risk graph.

If I thought RIMM was going to gap more than 11%, I may look at purchasing the strangle. What if I believe RIMM will not gap more than 11%? Well, I could look to enter a short strangle or perhaps an Iron Condor. Because condors have limited risk, I personally prefer them to short strangles. Let's take a look at 2 potential iron condors I could place on RIMM.

Iron Condor #1: 65-70 put spread plus 85-90 call spread
The 70-65 put spread is trading for $.85
The 85-90 call spread is trading for $.85
The net credit for the condor is $1.70
Max Risk = $3.30
ROI = 51%
Probability of Profit = 55%

Iron Condor #2: 65-60 put spread plus 90-95 call spread
The 65-60 put spread is trading for $.28
The 90-95 call spread is trading for $.28
The net credit for the condor is $.56
Max Risk = $4.44
ROI = 12%
Probability of Profit = 81%

Due to the lower deltas of the short call & put (90 & 65) in the second iron condor, the probability of profit is much higher (81% vs. 55%). The trade-off is we only receive $.56 total credit, which maybe insufficient for most traders.

I don't really have a strong bias one way or the other as to whether RIMM vol is cheap or expensive, but merely offer these option strategies up as examples for how to get long what you think may be cheap vol or short expensive vol into an earnings announcement.

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Wednesday, June 17, 2009

Mail Bag

Received a solid question in response to yesterdays Stuck in a Rut post.

Hi Tyler,

What was the main driver that led you to decide on the Bear Call Spread? What other play could you have done with today's market conditions?

There are a few reasons I chose OTM bear call spreads. First off, due to the breakdown that occurred on the RUT on Monday, my bias on the overall market turned to mildly bearish. Obviously with options there are a myriad of positions I can put on that profit from a downward move in price. Besides bear calls I may have considered buying puts, bear put spreads, or put ratio backspreads. Let's consider the advantages of entering a bear call spread vs. other alternatives:

1. Bear Calls are positive theta trades

The 3 primary variables that influence an options price are: stock movement, time, and implied volatility. Of these 3, time is obviously easiest to predict, followed by volatility, then stock movement. I'm an advocate of putting theta to work for me whenever possible, so the first reason I prefer bear call spreads vs. other bearish trades is they are positive theta.

2. OTM bear calls have a higher probability of profit

In yesterday's example I used a 570-580 July bear call spread. Based on the delta of the 570 call (which was .12), I have a probability of profit around 88%. In terms of price, RUT would have to rally above 570 by July expiry for me to lose on the trade. Thus, whether RUT goes down, sideways, or up, I have a very high probability of profit.

3. Personal Preference & Risk Tolerance

Some people may look at the bear call spread and balk at the "measly" $1.00 credit. They may prefer a higher potential reward trade. Others may be more aggressively bearish on the market and desire to enter straight puts or put spreads that afford more profit if we drop significantly. In my experience its much less painful (and I would say easier) to manage an OTM bear call spread vs. straight puts or ratio backspreads. In the end there isn't one right strategy or approach when bearish (or bullish for that matter) on the market. I've traded OTM credit spreads the most and have personally had the most success with them, thus they tend to be my bread and butter or go-to strategy. That's not to say that there aren't scenarios where other strategies are better choices though.


Tuesday, June 16, 2009

Stuck In a RUT

With yesterday's downdraft, the RUT now finds itself in the midst of a 30 min. downtrend. Now that we've broken below the last 10 days trading range, there is quite a bit of overhead resistance.
Consequently, it will be a tough road for the RUT to rally back through the range and break above it's major resistance at 535. As such, I will be considering entering July OTM bear call spreads on subsequent rallies into the range. Looks as if so far today, we may be presented with one such opportunity.
Currently the 570-580 July bear call is trading around $1.00 credit, which fits my personal preference and risk tolerance. The 570 call has a delta around 12, which puts the probability of profit at 88%. If we rally further, obviously I will adjust strikes as needed.


Monday, June 15, 2009

Fixed Delta and Risk Graphs

I've received a few questions as to how to manage or adjust a delta neutral, positive theta position (see my last post on Clash of the Greeks). I've already introduced the idiosyncrasies of delta in past posts, but want to start a new series of posts covering delta hedging. I'll be using risk graphs quite frequently so let's kick off the new series by highlighting the intricacies of delta on a risk graph.

In my original post on delta I stated,

"Rate of Change: This is the characteristic of Delta, most people are familiar with. Delta measures an option’s sensitivity to movements in the stock price. More specifically it measures the change in an options value given a $1 increase in the underlying. Bullish positions have positive delta, bearish positions have negative delta. Remember the following table:
Positive Delta = Long stock, Long Calls, Short Puts
Negative Delta = Short stock, Long Puts, Short Calls "

There are 2 types of Delta: Fixed and Variable
Stock has fixed delta, Options have variable delta.

Fixed Delta: If I were to buy 100 shares of a stock, my position delta would be +100. This means if stock were to increase $1, my stock position would profit $100. Whether the stock increases or decreases in price, my delta position is fixed at +100. On the other hand were I to short 100 shares of stock, my position delta would be -100. If the stock were to increase $1, my position would lose $100. Whether the stock increases or decreases in price, my delta position is fixed at -100. Simply put, for stock positions the delta never changes.

What's it look like on a risk graph?

Long 100 shares of SPY
What can we glean from the risk graph?
1.As you can see, the curvature of the line never changes. Why dat? Because the underlying position has a fixed delta.
2. Positive delta positions increase from bottom left to top right

Short 100 shares of SPY

1. Once again, the curvature of the line never changes as the position has a fixed delta.
2. Negative delta positions decrease from top left to bottom right.

A Delta Neutral Position

1. The curvature of line never changes as in this example the position has a fixed delta.
2. Delta neutral positions are shown as a horizontal line. Whether the stock increases or decreases, the profit/loss remains the same.

Before I delve into variable delta it's important to re-iterate what happens to an option at expiration. Remember an options premium is comprised of both intrinsic and extrinsic value (Premium = IV + EV).
Intrinsic Value is the amount the option is In-The-Money (IV = stock price - strike price).
Extrinsic Value is the amount you pay primarily for time and implied volatility (EV = Premium - IV).
At expiration there is no Extrinsic value left in option premiums. Out-of-the-money options expire worthless and In-the-money options will trade at their intrinsic value (sometimes called trading at parity). At expiration, delta for an option will either be 0 or 100.

If SPY was trading at $92 at options expiration, then all call options with a strike <92>92 will have a delta of 0. Take a look at the expiration risk graph of a long call:
When ITM the risk graph looks just like a long 100 shares risk graph (delta = 100). When OTM the risk graph looks like a delta neutral position (delta = 0)

In our next installment we'll explore variable delta and how it plays out on a risk graph.

Friday, June 12, 2009

Clash of the Greeks: Part Deux

In our first Clash of the Greeks post, I explored the inverse relationship between Theta & Gamma. If you missed it, you can view it here. I used a long straddle to illustrate a positive gamma, negative theta trade. In today’s post I’m going to review the nuances of a negative gamma, positive theta trade.

Negative gamma positions are positive theta positions.

Consider delta neutral trades such as iron condors or short straddles/strangles. They all make money as time passes (+theta), while looking for the underlying stock to remain relatively quiet (-gamma).

As mentioned in the original Clash of the Greeks post:

“We could say that when we enter trades that seek volatility, i.e. want the stock to move a lot or +gamma, we always have to fight time decay (-theta). Conversely, when we enter trades that profit from time decay (+theta), we constantly have to fight the stock moving too much (-gamma). Hence, there is a constant clash between Gamma and Theta.”

We can consider negative gamma trades, such as iron condors and short straddles, a race between time decay and underlying stock movement (realized volatility). For example, in the case of a short strangle we must make enough money due to time decay (+theta), to offset whatever money we lose due to the stock moving too high or too low (- gamma).

Suppose I enter a July short strangle on the SPY which is currently trading around 94. There are currently 35 days to expiration.

Short SPY July 98 Call for $1.15
Short SPY July 90 Put for $1.58

The net credit for the trade is $2.73. Both options are about $4 OTM, thus their premium is comprised of all extrinsic value. As long as the SPY remains between 98 and 90 at July expiration, both options will expire worthless allowing me to keep the $2.73 of premium.

The upside breakeven at expiration is 100.73. (98 + 2.73)
The downside breakeven at expiration is 87.27 (90 – 2.73)

With the breakevens at $100.73 and $87.27, all I need at expiration for the trade to produce a profit is the SPY to reside somewhere between these two points.

Viewing risk graphs helps to convey the trade-off between time decay and too much movement in the underlying. As a result of the time decay, SPY can move in a wider range as we approach expiration and still have the trade result in a net profit. In the case of the long straddle (used in last weeks Clash of the Greeks), we wanted the stock to move above or below the breakevens. Today's example is the opposite. As the risk graphs will portray, we want the underlying to remain in between the breakevens.
35 days to expiration
Breakevens = 91.50 and 94.75
18 days to expiration
Breakevens = $88.50 and $98.75
Breakevens = $87.27 and $100.73

As you can see, as expiration approaches, the break evens widen. This is a direct result of time decay. Thus, the longer we stay in this positive theta trade, the wider the range the stock can trade in and still result in a net profit. As is the nature with all delta neutral, positive theta, negative gamma trades, if the stock rises or falls too much the trade will lose money. Once again I've displayed a chart that juxtaposes the risk graph with the SPY price chart. In the first day or two, the SPY would have to remain within the two blue lines to result in a profit. With 18 days to expiration, the SPY would have to reside between the red lines. And finally at expiration the SPY would have to reside between the black lines to result in a profit.
I assumed implied volatility remained constant throughout the trade. In the real world, a rise in IV can hurt (shrink the profit zone) a short strangle, and a fall would help (widen the profit zone).


Thursday, June 11, 2009

Mail Time

It's high time for some viewer mail. In response to my Mythbusters- Naked Puts post, Mike asked the following question:

Just wondering why you would close out your position at $.20, as opposed to waiting another week or so and collecting the entire premium? Please explain......


Good question. The reason I close Naked Puts when they're almost worthless ($.20 or less), is the same reason I close any other limited reward trade- It gets to the point where the remaining reward isn't worth the risk. To me it is better to just lock in the profits and eliminate any potential of the trade turning against me. It's about being a smart investor, not a greedy one.

Once a naked put is down to $.20 or less, the risk-reward isn't favorable enough to stay in the trade. Ask yourself this- would you enter a new naked put trade if you were only bringing in $.20 premium? Most traders would answer to the negative. It's simply not worth it. Suppose your selling a 1 month 20 strike put for $.20. Your theoretical max risk is $19.80 and your max reward is a measly $.20. It's obviously not worth risking $19.80 to make $.20. Now some would say that $19.80 is merely theoretical risk and odds are pretty slim that the stock drops to $0 within 1 month. That's a perfectly valid point, so let's take the potential risk down to $3.00 instead of $19.80. I still wouldn't risk $3.00 to make $.20.

If you wouldn't enter a new trade that can only profit $.20, then you shouldn't stay in an existing trade with the exact same risk-reward characteristics.

Here are other posts on Naked Puts:

Bottom Line: Although it may be tempting to stay in to eke out the last $.20, in the long run it's usually not worth it.

[Addendum] Krengel Family brings up a good point in the comments section:

"Aside from the risk factor, it is also a good idea to look at the time factor. For example, the money that is going to be held up for margin could be used to open a fresh trade where it will make more over that same period of time, than to grab a few more pennies towards the end of a trade. That is one reason that I like to close them down if there isnt much life left in the trade."

I agree 100%


Tuesday, June 9, 2009

The Market is Vewy Vewy Quiet

"Be vewy vewy quiet, I'm hunting wabbits, heheheheheheh." Elmer Fudd

Following the breakout of last month's range between 875 & 930, you'd have thought we would have experienced a bit more volatility expansion than what we've seen over the last week and a half.

Surprisingly the last 6 trading days have all traded within last Monday's breakout candle. The SPX is in the midst of a time correction between 925 and 950.

As a direct result of this "vewy vewy" quiet market, most measures of realized volatility have continued to come in. The two measures of realized vol I follow the most are ATR (average true range) and HV (historical volatility). Current 14 day ATR levels on the SPX stand around 19 -meaning over the last few weeks the SPX has moved within a 19 pt. range on average per day. It's been quite awhile since we've seen the ATR sub 20. Low ATR levels often coincide with market tops. The trick is knowing what "low" is. Just because the ATR is sub 20, doesn't mean it can't drop lower before the market tops out. For past posts on ATR, click here.

Historical Volatility measures the realized volatility of a security over a given time period. Over the last 3 months the 30 day HV (blue line below) has diminished from mid 40's to mid 20s. Currently it sits at 25%.
So what's it all mean? To me it serves as justification for why the VIX has dropped to sub 30 over the last month. After all, it's tough to justify a 35 or 40 VIX when the SPX is only realizing 25% volatility. My guess is that before the VIX starts reversing upward aggressively, we may need to see an uptick in the realized vol of the market first.
However, I must admit the contrarian in me is starting to get antsy in getting long the VIX.

Monday, June 8, 2009

The Silver Lining

Within the commodity space, I've frequently highlighted gold (GLD), coal (KOL), nat gas (UNG) and oil (USO) in prior posts. Due to the resurgence in commodity stocks over the past few months, they've presented bullish opportunities aplenty. As Silver has exhibited a nice little bullish retracement pattern over the last week, I think it merits a post of its own.

The iShares Silver Trust (SLV) can be used to gain exposure in the silver space.

"The objective of the iShares Silver Trust is for the value of the shares of the iShares Silver Trust to reflect, at any given time, the price of silver owned by the iShares Silver Trust at that time, less the iShares Silver Trust's expenses and liabilities."

It seems as though the SLV does a pretty good job of tracking the price of silver as it closed today at $14.76 while silver futures were at $14.95.

Although gold has participated in the reflation trade over the last 3 months by rising around 5%, Silver has exhibited relative strength by rising 20% over the same time frame (click to enlarge).
Both GLD and SLV have exhibited bullish retracements to their rising 20 MA's over the last week. SLV has retraced to it's prior resistance point around $14.50. Both retracements are starting to look attractive.
If you're looking at actively playing commodity stocks, it would be wise to keep an eye on the greenback. Commodities and the dollar generally have an inverse relationship. Thus, a weak dollar serves as a tailwind for commodities. Conversely, a strong dollar typically serves as a headwind for commodities. For those of you that don't have a charting platform that supports currency pairs, you can use the UUP to track the price movements of the dollar. UUP is the PowerShares DB US Dollar Index Bullish- For those interested here is the overview of the UUP from MSN money:

It should come as no surprise the extreme weakness in the dollar over the past 3 months has been at least one factor helping to lift commodities.


Friday, June 5, 2009

Clash of the Greeks

As you progress as an option trader becoming familiar with the nuances of option pricing & theory can be quite advantageous. One such nuance I want to highlight today is the relationship between Gamma and Theta. If you're not already up to snuff with Theta and Gamma basics you can review my overviews here & here.

Gamma and Theta have an inverse relationship.

Positive gamma positions are negative theta positions. For example, long calls/puts or long straddles/strangles. They all lose money as time passes (-Theta), while seeking a big move in the underlying stock (+Gamma).

We could say that when we enter trades that seek volatility, i.e. want the stock to move a lot or +gamma, we always have to fight time decay (-theta). Conversely when we enter trades that profit from time decay (+theta), we constantly have to fight the stock moving too much (-gamma). Hence, there is a constant clash between Gamma and Theta.

We can consider the aforementioned positive gamma trades a race between movement (realized volatility) and time decay. The underlying stock must move enough (+gamma) so that my long options are ITM a sufficient amount (have enough intrinsic value) to offset whatever time decay (-theta) occurs. Suppose I enter a long June straddle on AAPL which is currently trading around $145. There are 14 days to June expiration.

Long Jun 145 Call for $4.45
Long Jun 145 Put for $5.30

The net debit of the trade comes out to be $9.75. Because both options are ATM, at trade inception the entire $9.75 consists of extrinsic value. Remember, at expiration options have no extrinsic value left. Thus, to break even I need to accumulate at least $9.75 of intrinsic value in either the call or put option by expiration. This would require the stock to rise or fall at least $9.75.

The upside break even at expiration is $154.75 (145 + 9.75).
The downside break even at expiration is $135.25 (145 - 9.75).

One of the easiest ways for illustrating the relationship between Gamma and Theta is via a risk graph. As a direct result of time decay (-theta), AAPL has to move more and more as we approach expiration for the position to be profitable. In other words, the upper and lower break even points for this straddle widen as expiration approaches. Consider the following risk graphs (click to enlarge):

14 days to expiration risk graph:
Break even points = $142, $147

7 days to expiration risk graph:
Break even points = $137, $153

Expiration risk graph:
Break even points = $135.25, $154.75

As you can see, as expiration approaches, the break evens widen. This is a direct result of time decay. Thus, the longer we stay in this positive gamma trade, the more the stock must move for us to be profitable.

Here is one other graph to consider. This displays the risk graph juxtaposed with the price chart. I've drawn horizontal lines to illustrate the range that AAPL must trade out of to be profitable in each time frame. Blue lines = 14 days to expiry. Red lines = 7 days to expiry. Black lines = expiration. For simplicity purposes and to better illustrate the relationship between Gamma and Theta, I assumed there were not any changes in implied volatility throughout the trade. In reality a change in IV will influence the break evens of a straddle trade.

In our next installment we'll discuss examples of negative gamma, positive theta trades.