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.



Tim Justice said...

Interesting post Ty....It's hard to neutralize each and every greek therefore I find it easier to manage account delta rather than individual delta.....I also find it lest costly to the bottom line.

Happy Trading!


Tyler Craig said...

I'm with ya Tim. In reality it's impractical to be delta neutral all the time- definately too costly. The end goal isn't necessarily to be completely delta neutral either, which is why it's important to define your comfort zone as to how much + or - delta you're comfortable accumulating. For trades like IC's and short strangles, the obvious hope is that the underlying stock behaves well enough so one need not hedge at all.



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