Thursday, October 29, 2009

It Takes Two to Contango...

Today's VIX Sonar Report had a great explanation of Contango versus Backwardation in VIX futures.

In Monday's Mail Time- VIX Options post, I alluded to Contango and Backwardation and the effect each can have on VIX options.

The CBOE also put out a 5 minute video comparing the VIX today vs. a year ago. I had trouble embedding the video, so just click on the following if you want to view it: CBOE VIX Video

Wednesday, October 28, 2009

Volatility Skew and Ratio Spreads

In the McMillan chat I referenced earlier, he talked about put ratio spreads on the SPY. Though I'm familiar with ratio spreads, I haven't used them that often in my own trading. The most recent instance being the 1x2 put spread mentioned in the Sept. post: Oil Triple Play Part I.

McMillan discussed the negative volatility skew that exists in SPY options where OTM puts trade at higher implied vol levels than ATM puts. To exploit the skew (i.e. buy options with lower implied vol while selling options with higher implied vol), the thought was to buy an ATM or slightly OTM put while simultaneously selling multiple further OTM puts. So instead of buying a run of the mill put vertical spread where you buy and sell an equal amount of contracts, the ratio spread involves selling more contracts than you own.

Take a look at the following SPY option chain:
[Source: EduTrader]

Notice how the IV increases as you move further OTM. Let's look at two put ratio spread examples.

SPY November 104-101 1x2 put spread
Long (1) Nov 104 put @ $2.55
Short (2) Nov 101 put @ $1.54
Net Credit = $.53
[Source: EduTrader]

If you wanted to widen the profit zone, rather than selling 2 of the same strike, you could sell 2 different OTM strike puts. For example:

Long (1) Nov 104 put @ $2.55
Sell (1) Nov 101 put @ $1.54
Sell (1) Nov 99 put @ $1.12
Net Credit = $.11

[Source: EduTrader]

Based on the risk graph, you can see it's basically a mildly bearish play. Ideal scenario is to have the stock sitting around the short strikes at expiration. Due to the additional naked short puts, there is downside risk if the SPY tanks. However, if you enter with a credit there isn't any upside risk, so there's a bit of a trade-off there. All in all I think it's a decent strategy to exploit overpriced OTM puts if you're mildly bearish.

Larry McMillan on Volatility

Every week brokerage firm Think or Swim hosts a live chat session containing a mixed bag of trader talk. When I first started trading, these trader chats helped in introducing some of the finer points of volatility, the greeks, and other option nuances. Thus far my favorite chat has been the one given on March 12, 2008 concerning "Volatility and Option Pricing" with guest host Ron Ianieri. Unfortunately I haven't had much time to participate in these recently, however I ventured into their chat archive the other day and was pleased to find that last week's chat included special guest host Larry McMillan expounding on some interesting volatility lessons.

Though its around an hour long, its worth a listen if you get a chance: TOS Chat Archive.

I plan on doing a post on one of the option plays he talked about. Stay tuned...

Monday, October 26, 2009

Mail Time- VIX Options

I received a question in regard to VIX options I wanted to tackle for this week's Mail Time post.

Something in the VIX option chain puzzles me and I wonder if you have observed the same phenomenon. The front month puts have higher premiums than latter month puts at the same strike price. This implies negative time value, which doesn't seem to make sense to me. Would you have an alternative explanation?


The short answer is that VIX options don't price off of the spot or cash VIX that most traders are looking at. VIX options are based off of VIX futures.

Keep in mind when the VIX futures are in contango (upward sloping over time with the second month trading higher than front month), this creates a scenario where the same strike put for front month options can be more expensive than longer dated options. This can be true because the back month puts are actually further OTM. Thus, although later dated options have more time to expiration (leading most to believe they should be worth more), they're not usually worth as much as you would think.

Now, if VIX futures were trading at similar prices or in backwardation (downward sloping over time), then you'd see the VIX options chain looking more like a normal equity options chain, with longer dated options priced more expensive.

There are caveats aplenty when it comes to trading VIX products. To tell you the truth, I'm still becoming acquainted with their idiosyncrasies myself. One such caveat to consider is the fact that VIX futures don't always move in tandem with the cash VIX. Since there's not really anything that ties VIX futures to the VIX cash, they don't have to move in lock step and often wander apart. However, they do converge at expiration, so as I've mentioned in the past the discrepancy between front month futures and the VIX cash will begin to diminish as expiration approaches. Consider the following setup:

Cash VIX at 23, November VIX futures at 22.

Suppose you think the VIX is oversold in the short term and want to exploit the expected rise in price by selling the Nov 22.50 puts for $1 credit. Fortunately you're right on and the next day the VIX rises to 26. Naturally, you would expect that the 22.50 puts to drop in value, but...

Not so fast!

Though the spot VIX rose to 26, let's say the NOV futures remained at 22. Given that the futures didn't budge, you're 22.50 put is probably still worth about $1.

Why might the cash VIX rise, but November futures remain low? Since the VIX is a mean reverting animal, the futures are perpetually pricing in or discounting any reversion to the mean expected to take place between now and expiration. So the short term pop in the cash VIX may be treated as an anomaly that's expected to come back down towards 22 by Nov expiration.

Take a look at the following Puts Matrix, focusing on the 22.50 strike (click image to enlarge):

[Source: OptionsXpress]

Now, consider the following table:

As you can see, the 22.50 puts are all trading around the same price. Despite the February options having 5x as much time to expiration as the November options, they are still identical in price (roughly). This would certainly not be the case in a normal equity option chain. As mentioned, this can be attributed to the mean reversion discounted in the futures which places the Feb 22.50 puts twice as far OTM as the Nov 22.50 puts.

This should help in understanding why it's probably more beneficial to use front month options when selling puts or put spreads on the VIX vs. back month options.

For related post, check out:

Sunday, October 25, 2009

Relative Performance of Energy

With a bevy of earnings from energy companies set to report this week, I thought it may be beneficial to take a birds eye view at the performance of the energy sector relative to the S&P 500 and other major sectors over the past 2 months. Given the resurgence we've seen with oil in recent weeks, one would expect that energy has performed relatively well (click image to enlarge).
[Source: Yahoo Finance]

Over the past 2 months (Aug 24 - Oct 23), the Select Sector Energy SPDR (XLE) is up about 10%. As the relative performance chart shows, it has succeeded in outperforming every other sector. As one would expect, XLE finds itself in the midst of a rather strong uptrend.

[Source: EduTrader]

The following heavy hitters are set to report this week:

Monday: National Oilwell Varco (NOV)
Tuesday: Valero Energy Corp. (VLO)
Wednesday: ConocoPhillips (COP)
Thursday: Exxon Mobil Corp. (XOM)
Friday: Chevron Corp. (CVX)

The question at hand is whether or not the earnings releases will add fuel to the energy sector fire, or curb its relative strength.

Give a Man a Fish...

Last weekend I kicked off a new series of what will be relatively sporadic posts concerning politics, economics, history or anything else I find interesting in my leisure reading. Given that I'm still immersed in Reagan's book, I offer up another excerpt expounding on Reagan's measuring stick for government welfare programs.
...Reagan had introduced the topic into the national debate and offered a new criterion for evaluating government programs. Until then, many public officials and policy experts considered a government program a good one if it covered a lot of people. The more people who received benefits, the more successful the pundits and bureaucrats regarded the program. This was the logic of the Great Society. Reagan, by contrast, said that the Great Society approach was a failure. "We declared war on poverty," he famously quipped, "and poverty won." Reagan did not dispute that government has a responsibility to help the poor, but he argued that you cannot free people by making them dependent on the state. "The best social program," Reagan liked to say, "is a job." He insisted that welfare programs be measured by the degree to which they encouraged self-reliance. The purpose of welfare, he said, "should be to eliminate... the need for its own existence."
I tend to agree. Self reliance and curbing or eliminating some one's need for help from the government seem like worthy ideals to me. As the Chinese Proverb states: Give a man a fish, feed him for a day. Teach a man to fish, feed him for a lifetime.

Perhaps we should spend more time teaching or incentivizing people how to fish as opposed to simply giving them fish.

For related posts, check out:

Saturday, October 24, 2009

The Blog Formerly Known as "Know Your Options"

Given the rise in viewership on my blog and its subsequent rise in google ranking, I've apparently come under the scrutiny of the entity that trade marked the phrase "know your options". As such I've been requested to refrain from using that particular phrase from this point forward. I've got mixed feelings, but...

...C'est la vie!

Fortunately, it's not the name that makes a blog but the content. So from here on out, "Know Your Options" is now "Tyler's Trading: Reflections of an Options Trader"

Friday, October 23, 2009

Saved By The Wings

So turns out the pessimistic view mentioned yesterday had the upper hand this go around with AMZN earnings. Indeed it was time for another trip to the woodshed for volatility sellers. It's like ISRG from last season all over again. This is the EXACT reaction condor traders use as the rationale for why buying the wings to limit risk is worth the extra commission/slippage and lower reward.

It's also the exact reaction that short strangle traders pray at night they never see. But the truth is you sell enough options gamma in front of earnings, you're bound to pay the piper sometime. Unfortunately the piper has a knack for showing up unannounced and unexpectedly.

So how would have buying wings been a saving grace with AMZN? And by "saving grace", I mean would have kept the loss somewhat survivable vs. the grenade going off in your face variety. Let's run some numbers:

Suppose you shorted an 80-105 Nov strangle yesterday bringing in $.90 for the put and $1.25 for the call. Given that AMZN opened around $112 this morning you would have found the put next to worthless ($.90 gain) and the call worth around $10 ($875 loss). So you're down about $800 PER CONTRACT. Bad enough had you even sold 1, let alone 3, 5 or 10.

How's about the 75-80 105-110 Iron Condor?

Well the put spread would have been worthless ($50 gain or so). The call spread was only down around $300, bringing the net loss to around $250. Which needless to say would have been a heck of a lot more manageable than the strangle.

Adam Warner of Daily Options Report brought up a great point in his post When Estimates Fail:

So goes the plight of any trader selling options gamma into earnings. Though they get to bask in the supposed "easiness" of profiting from the all but guaranteed volatility crush. Those pesky outliers are perpetually lurking in the shadows waiting to pounce a few times every earnings season.

For related posts, readers are encouraged to check out:

Thursday, October 22, 2009

Zeroing in on AMZN Earnings

After the bell, Amazon reported a third quarter EPS of $.45. Given that analysts' estimates for EPS was around $.30, it's fair to say AMZN knocked the cover off the ball. Following the announcement traders immediately began aggressively bidding up shares in the after-hours trading session. Though AMZN saw it's stock price close today's trading session nearly unchanged at $93.42, it was recently trading up to $106.50, a 14% increase.

Due to a few meetings that have required my attention today, I was unable to do a pre-earnings post on AMZN. Nevertheless, I still want to offer up a few volatility thoughts regarding the online retailer (these were penned before tonight's announcement).

Like AAPL, AMZN has seen its IV rise to the same level it was at prior to last quarters earnings announcement (47%). Which basically means the expected rise in realized vol due to the usual earnings gap are expected to be somewhat in line with last quarters earnings announcements reaction (click image to enlarge).

[Source: Livevol Pro]

A comparison of front month straddles (day before earnings vs. day after) over the last 7 earnings announcements, shows that vol sellers have won or broken even (roughly) 6 out of 7 times. The one loss is boxed below in blue. Perhaps there are two different ways to dissect this information. Let's first assume we're volatility sellers (not a stretch considering I usually am).

[Source: Livevol Pro]

On the one hand, which we'll call our 'optimistic' hand, we could assert this certainly puts the odds in the favor of vol sellers as it seems the volatility bid up has been consistently overdone in virtually every announcement over the past two years.

On the other hand, our ‘pessimistic’ hand, I suppose we could assert that perhaps we’re due for large reaction rewarding vol buyers simply because it hasn't happened for awhile.

Though I'm not sure which view I like better (ask me tomorrow when I have the gift of, they are both certainly worth considering.

In the end, no matter how much data we mine through, there’s still no way to forecast the future with 100% reliability. I’m assuming, indeed hoping, all of you know that. It certainly helps to assess past earnings reactions as a guidepost for what the "norm" is regarding implied and realized volatility around earnings. But we must concede that each earnings is unique and anything can happen. Hence the need for risk management, position sizing, yada yada yada...

Wednesday, October 21, 2009

VIX Settlement

Settlement prices for Oct. VIX options and futures was released an hour or two ago.
[Source: CBOE]

[Source: EduTrader]

Given that the cash VIX opened the day at 20.90, the settlement price of 20.82 seems in line and void of any dastardly attempts in skewing settlement. The naked put mentioned in last weeks Surveying the Volatility Landscape was obviously a bust. We'll see if any opportunities arise for the November cycle.

The One That Got Away

So I must have missed last night's earnings announcement on Intuitive Surgical (ISRG). Since it usually has a big volatility lift into earnings I typically throw it on my radar each earnings season. Perhaps I subconsciously decided to avoid all things ISRG after the shlacking I took during its last earnings announcement. Last go around I mentioned a short vol strategy in my post titled Earnings Intuition, which given the outcome of the trade we can now deem as the worst titled post EVER.

Well, consider last night's announcement and today's reaction vindication for vol sellers. Though last earnings announcement resulted in a 20+% gap, currently ISRG is down a mere 6% and IV is taking it on the chin.

The pre-announcement bid up had IV30 trading at 56%, a hefty premium to 20 HV at 35%. Given the virtual non-event the reaction has turned out to be, we can now say that vol bid up was all for naught. Currently IV30 is down 19pts. to 37%. A volatility crush at its finest!
[Source: Livevol Pro]

I ran the numbers on a Nov 310-320 220-210 Iron Condor that could have been sold yesterday for $2.10 credit. Traders had the chance to exit this morning around $1.00 debit, resulting in about 50% of the potential profit. Though that $1.00 profit probably pales in comparison to the losses from short vol strategies last earnings season, it may just assuage a bit of the leftover pain.

Monday, October 19, 2009

An AAPL a Day

In preparation for Apple Inc. earnings set to be released tonight, let's take an in depth look at its volatility characteristics.

After reaching a 52 week low of 27% on July 22nd, AAPL's implied volatility has increased gradually up to 37% in anticipation of tonight's earnings announcement. Ironically, the 52 week low was reached as a result of the volatility crush experienced after last quarter's earnings announcement. Furthermore, IV has since run right back up to where it was sitting the last time AAPL reported earnings.

[Source: Livevol Pro]

Unlike implied volatility, 20 day HV is currently sitting around 18% - not only a 52 week low, but the lowest its been for over two years. So... suffice it to say there's a notable difference between HV and IV.

Livevol Pro includes an earnings and dividends tab chalk full of useful information for analyzing volatility plays into earnings. In addition to displaying the underlying's price 5 days pre and post earnings, it also displays changes in the value of a front month and second month straddle as well as changes in implied volatility for both. This allows the user to glean insight into the average amount of volatility crush experienced post earnings, as well as how a volatility buyer or seller (via a straddle) would have fared.

[Source: Livevol Pro]

The graphic below displays the actual change in value of a front month straddle for the past 2 years of earnings. I used the straddle value on the day before earnings and compared it to the straddle value on the day after earnings. The table helps in assessing how efficient the options market was in pricing in the expected post earnings move in the underlying. Out of the seven earnings analyzed, five resulted in options being overpriced and two resulted in options being underpriced (click image to enlarge).

The table helps illustrate why most professional traders probably prefer selling volatility into earnings. More times than not, options are too pumped up.

But here's the rub. The times when a stock ends up gapping more than expected can be quite painful for vol sellers. Who cares if I win 5 out of 7 short volatility plays if on the 2 losers I get steamrolled? In the end I believe this exercise simply reiterates the importance of sound risk management. Though it doesn't take a genius to tell you there's an edge in favor of vol sellers into earnings, it does require at least a savvy trader to play earnings profitably over the long run. Make sure you exercise sound risk management rules like diversification and proper position sizing.

As for AAPL this go around, I'd probably lean towards selling vol via a strangle or iron condor.

Tech on Deck

Though the likes of RIMM, GOOG, INTC, and IBM have already reported earnings, we still have a bevy of tech earnings on the horizon. As far as the reactions so far, I think it's fair to say we've seen a mixed bag with the negative reactions coming in a bit more severe than the positive reactions. As of the day after earnings, here's the breakdown thus far:

RIMM = down 17%
GOOG = up 3.7%
INTC = up 1.6%
IBM = down 4.9%

With the muted reactions experienced in all but RIMM, short vol strategies had the upper hand. Though we haven't seen a huge run-up in volatility pre-earnings in most names, it seems to be justified thus far. Looking forward, we have quite a few heavy hitters coming out this week.

Monday- AAPL
Tuesday- YHOO
Wednesday- EBAY
Thursday- AMZN
Friday- MSFT

I plan on doing posts on a few of these highlighting volatility characteristics going into earnings.

Sunday, October 18, 2009

The "Perks" of the Poor

As I've grown older (given that I'm only 25, perhaps I should say "less young"), I've become increasingly enamored by politics and the constant debates between opposing parties. Being an avid reader, I've found myself spending more time on texts expounding on politics, history, economics, etc... Currently I'm reading a book titled Ronald Reagan How an Ordinary Man Became an Extraordinary Leader. Thus far, it has included quite a few passages that have resonated with my line of reason. Though I don't profess to be an expert when it comes to the political scene (curious on-looker is probably more accurate), I thought it may be fun to share the occasional excerpts that either ring true with my thought process (which I like to consider common sense), are funny, or have relevance to present day issues.

For those of you that are clamoring, "booo with politics! Bring on the options posts!" No worries, these posts may just turn out to be few and far between.

Reagan regaled his audiences with countless stories over the years. In one of his favorites, he dramatized what he saw as the bizarre and counterproductive effects of government benefits for the poor and underprivileged through the example of a man who discovers that "you can get subsidized housing, health and dental care, university scholarships and other welfare benefits, provided you're poor enough." So the man approaches his boss and asks for a pay cut. "If I make less," he explains, "we'd be eligible for an apartment in the city's new development, the one down town with the pool, sauna, and tennis court. Besides, my son would qualify for government scholarship and we could get his teeth fixed at government expense." His boss says fine, but on one condition: "if your work slips, you'll get a raise!" The man is grateful, but on his way out the boss asks to be invited for tennis and a swim some night when his employee gets into his new place. "Certainly sir," the man says. "I believe the poor should share with the less fortunate!"


Wednesday, October 14, 2009

Surveying the Volatility Landscape

Though VIX options usually expire the Wed prior to equity options expiration, the October cycle finds VIX expiration falling on the Wednesday(21st) after it. As mentioned in last months Lessons Learned from a Put Matrix, I like to keep an eye on VIX options each expiration cycle, particularly as the expiration date approaches in an effort to discover trade opportunities.

A quick survey of the current volatility landscape yields the following:

SPX 21 day HV = 17%
VIX = 22.86
Oct VIX futures = 23.50
Nov VIX futures = 25.30

Though the Oct futures are trading at about a 1 pt. premium to the cash VIX, that discrepancy will diminish as expiration approaches (either cash rising to futures or futures falling to cash). Given the shlacking that the VIX has taken over the last 8 trading sessions, it's quickly coming in line with the realized volatility we're seeing materialize in the SPX day to day. Tack on the fact that the VIX is oversold by just about every measure out there (% below 10 SMA, RSI, Stoch, et. al.) and you've got a pretty decent argument that the VIX is close to a short term bottom (click image to enlarge).
[Source: EduTrader]

One other quick observation regarding today's price action. I find it somewhat interesting that despite the SPX's explosion higher, the VIX was still able to close near the high of day. I don't mean to fall into the trap of hyper analyzing every tick in the VIX, but.... just sayin.

As mentioned in prior posts, my play du jour on the VIX tends to be selling naked puts. So what's in play between now and next Wed? Of the Oct strikes available, the 22.50 put is the only one I see worth considering. The Oct 20's have no bid and the Oct 25's are a too far in-the-money IMO. Selling the Oct. 22.50 puts for around $.50 gives the following risk graph (click image to enlarge):

[Source: EduTrader]

For related posts, check out:

INTC... the Aftermath

In light of Intel's after hours surge and subsequent gap and crap, let's deconstruct its 3Q earnings saga.

A Price Perspective:

[Source: Think or Swim]

1. The Surge: After beating the numbers, INTC saw a strong upward surge in its stock price- reaching an after hours high of $21.90 or up 6.8% from its close.
2. The Gap: Although INTC gave back a portion of its after hours gain, it still opened this morning at $21.26 or up 3.7% from yesterday's close.
3. The Crap: INTC lost momentum right off the bat as the gap was met with immediate profit taking. The "crap" has since stabilized a bit reaching a low around 20.90 or about 2% above yesterday's close.

A Volatility Perspective:

In anticipation of the earnings announcement, INTC options saw the classic pre-earnings IV bid up, as IV30 (red line) rose from 29% on Aug 25th to 38% by yesterday's close. Though the 9 point bidup doesn't seem that big in the Livevol Pro graphic below, it was a 31% increase making it at least notable. Keep in mind the pre-earnings IV bidup is merely a reflection of the option market trying to price in the gap in stock price (and subsequent increase in actual or realized vol) that usually occurs after earnings. Notice how the lift in IV placed it about 15 pts. higher than the HV20 (white line). Remember, the HV 20 is a measure of how volatile the stock has been over the past 20 trading days. The IV30 gives us an indication of how much volatility INTC is expected to realize over the next 30 calendar days. Whether or not this "higher" IV30 is justified obviously depends on how much volatility INTC realizes going forward (click image to enlarge).

[Source: Livevol Pro]

The post earnings vol crush so far has seen a 7 pt. drop (18%) back down to 31%.

Based on the aforementioned analysis, I think the volatility battle for INTC earnings had a decisive winner. Maybe not a huge winner, but decisive nonetheless...

Volatility sellers!

A simple method for selling volatility could have been shorting a Nov 21-20 strangle. It could have been sold yesterday for about $1.52 and bought back today around $1.20. The one-two combo of lackluster price reaction and volatility crush served to be too much this go around for vol buyers.

Better luck next time... suckers! Consider it payback for RIMM-

For other related posts, check out:

Monday, October 12, 2009

Mailbox- Strangles vs. Iron Condors

Received this question in response to my GLD Stranglehold post.

Why not always put on iron condors instead of strangles? You're paying some for the wings, but it reduces your capital outlay so much (lower margin) that the trade, if successful, has a much higher ROI. I'm not sure what the down-side of the IC over a strangle would be, aside from higher commissions and a slightly reduced profit range...

Thanks for the question. You already alluded to two of the differences. I'll start with the disadvantages, then move on to the advantages of the iron condor over the strangle.

Disadvantages of iron condor vs. short strangle:
-2 extra legs
-2x as many contracts (increased commissions)
-Less potential profit

Although most explain the structure of an iron condor as simultaneously entering a call vertical and put vertical spread, another way to think about it is as a short strangle plus a long strangle (protection). In a minute we'll review an example on GLD where we short the 113-97 strangle and buy the 118-92 strangle as protection. Because we're buying the "wings", the condor involves 2 extra legs. Which means we have to navigate 2 more bid-ask spreads, and pay commission on twice as many contracts compared to the strangle. In addition, buying the wings does cost money, so it reduces the profit potential on a dollar basis vs. the strangle. These are the three most common cited disadvantages I know of when entering an iron condor vs. the strangle.

Advantages of iron condor vs. short strangle:
-Less/Limited Risk
-Lower margin requirement

Despite the aforementioned disadvantages to the condor, there are certain advantages as well. As mentioned in the question, condors do typically reduce the margin required to enter the trade. Whereas the strangle has theoretical unlimited risk, the condor's risk is limited to the difference between strikes less the credit received. In addition, the margin required for the condor is fixed and thus doesn't change after you enter the trade. The margin required for the strangle, on the other hand, can change if the stock moves adversely. So in addition to having enough capital up front to enter the strangle, it would be wise to not max out all your buying power in other trades so you have additional funds if needed.

GLD 113-97 strangle
Reward = $142
Risk = Unlimited
Margin required ($1416.50)... roughly 10% of stock price
ROI = $142/$1416.50 = 10%

Note- the margin required may differ depending on your broker or if you have portfolio margin. I used Think or Swim for the calculation.

GLD 97-92, 113-118 iron condor
Reward = $92
Risk = $408
Margin Required= $408
ROI = 22%

Set aside the fact that the condor has a higher ROI for a minute. Let's say we want to receive around $3.00 of credit in either trade. Since the strangle brings in $142 credit, I would merely need to sell 2 strangles (4 contracts). The condor brings in $92, so I'd have to sell 3 condors (12 contracts). Depending upon how big your account size is and how many contracts you're dealing with, the condor can potentially rack up trading costs much quicker than the strangle.

I don't mean to overemphasize the importance of trading costs per se, nor am I recommending that it should be the only factor influencing whether you take one trade or another. I merely want to point out it is one legit difference between the two strategies. Truth is, some traders shun naked strangles like the plague and would never trade them due to the theoretical risk. In addition to personal preference, it also depends on the situation. In certain circumstances I don't mind selling strangles vs. condors. Just depends on the underlying and whether or not I'm willing to pay up for the protection inherent with the condors.

For example, on cheaper stocks (like the USO) the difference in margin on a strangle vs. a condor becomes less significant.

The Trade Off: Risk-Reward vs. Probability of Profit Part Three

If you missed the first two installments of The Trade Off: Risk-Reward vs. Probability of Profit, check them out here:

Once a trader understands the relationship between risk-reward and probability of profit they typically ask the following question: How do I change the risk-reward or probability of profit of a vertical spread? The answer lies in changing the strike prices one is using in the trade.

Let's use a bull put spread on the S&P 500 to illustrate. Suppose the Index is currently trading at 925. Using current option prices I have constructed a table illustrating three potential bull put spreads we could place on the Index. Pay close attention to the difference in the risk-reward and probability of profit (click image to enlarge).

The risk-reward and probability of profit characteristics of these three spreads holds true to our prior assertion that as we increase the probability of profit, generally we lower the maximum reward. For example, although the 1000-990 put spread has the best risk-reward characteristics, risking $275 to make $725; it also has the lowest probability of profit. Remember, the Index is currently trading at 925. To realize our maximum reward on this spread, the Index would have to rise 75 points to 1000. On the other hand the 880-790 put spread has the worst risk-reward, risking $855 to make $145; but has the highest probability of profit (84%). To realize the maximum reward on this spread we simply need the Index to stay above 800; not a hard proposition considering the Index is already trading at 925.

This is the primary reason why there is not a cookie cutter approach to entering vertical spreads. whereas one trader may enter a bull put spread by using puts one or two strikes OTM, another trader may use puts that are four or five strikes OTM. The bottom line is to make sure that you're comfortable with the risk-reward AND probability of profit characteristics of the trade.

Saturday, October 10, 2009

Mail Time- Delta Hedging

I received a question in response to my Playing with Semis and The Trade off: Risk-Reward vs. Probability of Profit posts. I would have just answered in the comment section but either due to my technological ignorance or Bloggers weak sauce program, I'm not sure how to enter hyperlinks or edit other text within the comments section.

Speaking of the comments section.... some of you may not be aware that at the end of every post, there is indeed a comment section where you can post thoughts, questions, disagreements, or random musings.

On to the questions at hand (in blue):

Greetings Tyler:

...if you have more discussion of delta hedging, please point me to it...

Besides my prior posts on Delta, I have yet to do a solid series of posts on delta hedging. One of these days I'll get around to it. A few weeks back Condor Options had a well written post titled: The Lazy Guide to Delta Hedging. It's worth a read when you get the time. Also, Sheldon Natenberg's book Option Volatility and Pricing contains some solid information on delta hedging as well.

A couple follow up questions:

If you exit (vertical spreads) when you achieve 80% of credit, does this number factor into the spread selection? Since you put this (the bear call spread on SMH) on for 15% max ROI but will really get more like 12% if you exit at 80% credit collected. Which ROI are you looking at when you put it on?

Usually I'm looking at the 15%. Although I'm almost always exiting prior to expiration without achieving the entire potential profit, the last few percent aren't a big deal IMO.

A few more on delta hedging. What do you mean by "daily resistance"? Resistance on the daily chart or intraday resistance?

To me daily resistance = resistance on the daily chart. Weekly resistance = resistance on the weekly chart. 5 min. resistance = resistance on the 5 minute chart. etc...

If you delta hedge - I am assuming that you are using the underlying here. When do you take the hedge off? Do you have a stop out for the hedge? Do you leave it on overnight?

In the case of a call spread on SMH, yeah I would use the underlying stock to hedge (if I decide to hedge the position). The timing for hedging a directional trade is subjective and depends on the trader IMO. The general idea would be to hedge when the position is moving adversely (up in this case). Then take the hedge off when the stock is moving the right way (down). Rather than hedging at random, one could use technical analysis in an attempt to have more precise, rationale entries/exits on the hedge. If SMH stays neutral to bearish, then no need to hedge. It's doing what we want it to do. If SMH started to get more bullish, one may consider delta hedging by buying shares of stock. Generally breaking resistance is what changes my personal outlook on a stock, so I may use a break of resistance as my trigger for when to hedge.

I do have a stop for the hedge (long stock in this case). Last thing I want to do is lose more money on the hedge than what I realize in the original trade. At some point I've got to exit the hedge if SMH starts going back down in price. You could potentially use a daily low as your stop.

I do leave it on overnight if needed. I would hate to have to re-establish a hedge EVERY single day and rack up commission costs.

Finally, why would you exit vs. delta hedge? Is this just based on a max loss on the initial spread being hit?

Keep in mind that delta hedging is a complex subject and it's very hard to give one specific answer to any question. The majority of the time there isn't one "right" answer. Deciding when to hedge, how to hedge, whether to hedge or exit, etc... comes down to personal preference, risk tolerance, and the type of position. Hedging a position meant to be delta neutral, such as a condor or strangle, is much different than hedging a directional trade, such as a long call or vertical spreads.

On to the question. I usually choose to exit directional trades rather than hedging. Delta hedging is quite complex and for most traders they would be better off just closing the original position if it moves adversely. Think about all the additional questions that you need to consider when hedging:

When do I delta hedge?
What should I use to delta hedge?
How much do I hedge?
When do I take off the hedge?
When do I put it back on?
When do I increase or decrease the hedge?
If I delta hedge and the position continues to move against me, when do I just scrap the trade instead of continuing to hedge?

Some traders would rather say, "OK, I was wrong. I'm simply getting out to minimize the loss." Rather than delta hedging and trying to tackle all the aforementioned questions. Delta hedging requires a lot more active management than some people want to put in.

I've got another question regarding naked strangles vs. iron condors that I'll tackle next week.

Friday, October 9, 2009

The Trade Off: Risk-Reward vs. Probability of Profit Part Two

The following table uses a $10 vertical spread to illustrate the trade off between probability of profit and risk-reward.

While there may be situations (based on time to expiry & other factors) where a $10 vertical spread deviates from the table, the majority of the time the relationship between risk-reward and probability of profit will hold true. In short, the higher the probability of profit, the lower the maximum reward. Conversely, the lower the probability of profit, the higher the maximum reward. Typically when trading stock, we can simply use risk-reward to determine whether or not a trade is worthwhile. As the options arena is a bit more complex, many option strategies require us also to assess the probability of profit. It's insufficient to simply know that one is risking $5 to make $10. We also need to establish the likelihood of realizing the $10. Let's look at two extreme examples to illustrate the point.

For our first example, consider the following question. Would you risk $9 to make $1? Most traders would immediately answer with an emphatic no! After all, you would be taking on quite a bit of risk, for a paltry reward. However, let's shed a little more light on this trade by further assuming that your probability of realizing the $1 gain is 95%. Would this influence your decision? It most definitely should! Given this extremely high probability of profit, this trade would probably be a winner in the long run.

For our second example consider this question: Would you risk $1 to make $9? Most traders would answer to the affirmative! Moreover, it seems as if it's a no brainer. However, let's add in probability of profit. Suppose the probability of realizing the $9 is a mere 8%. How would this influence your answer? Hopefully it would cause you to avoid the trade and find a better one. Although the risk-reward makes the trade appear like a no-brainer, the small probability of profit better make you think twice! In the long run this trade will probably be a loser.

Hopefully these examples are helping you to begin to realize the significance of not only looking at risk-reward, but also probability of profit.

Looks like this two part series in turning into three parts. Next time I'll review how to change risk-reward and probability of profit by choosing different strikes.


Doesn't the Nobel Committee watch What are the odds that less than a week after SNL finally gives some justly deserved criticism to Obama for his lack of accomplishments, he receives a Nobel Peace Prize for, well, his accomplishments.


Is it just me or did the prestige of the Peace Prize just drop a notch or two... or ten?

On a completely unrelated note, I'll post part two of Probability of Profit vs. Risk-Reward later today.

Thursday, October 8, 2009

The Trade Off: Risk-Reward vs. Probability of Profit

When entering the realm of options spread trading, it is imperative that a trader understands probability of profit. Not only how to calculate it, but also the role it plays in the decision making process. I would hope most visitors to this blog are already cognizant of this concept, but there are no doubt newcomers to the options arena that might benefit from an overview. In my next two posts I'll review a simple method for calculating probability of profit and illustrate the relationship between increasing probability of profit and decreasing risk-reward. Be forewarned, there will be some math involved, so hold your head still so nothing spills out!

As a precursor to calculating probability of profit, a trader must first understand the greek delta. One of the characteristics of delta is it calculates the probability of an option expiring in-the-money. For example, suppose stock XYZ is trading at $100 and the 90 strike put option has a delta of .20. This means there is a 20% probability that the 90 strike put will be in-the-money at expiration. Put another way, there is a 20% probability the stock price will be below $90 at expiration. Now, we can use a little arithmetic to calculate the probability of an option expiring out-of-the-money. We can all agree that there is a 100% probability of the stock price residing somewhere. If there is a 20% chance the stock will be below $90, then it stands to reason that there is an 80% chance of the stock residing above $90 at expiration. Thus the formula for calculating the probability of an option expiring out-of-the-money is: 1 minus delta.

Although delta can be used to calculate probability of profit on most option spread trades, I'm going to focus on vertical spreads. Remember, the four verticals are the bull call, bull put, bear call, and bear put spreads. The two bullish spreads consist of buying a lower strike option and selling a higher strike option of the same type in the same expiration month. To realize the maximum profit we want the stock to be above the higher strike price at expiration. Alternatively, the two bearish spreads are constructed by buying a higher strike option and selling a lower strike option of the same type in the same expiration month. Capturing the maximum profit on these two spreads requires the stock to be below the lower strike price at expiration. To calculate the probability of profit on a bull spread, simply use delta to calculate the probability of the stock residing above the higher strike. Conversely, for a bear spread calculate the probability of the stock residing below the lower strike.

Suppose stock ABC is trading at $50 and we enter a bull put spread by simultaneously buying the 40 put and selling the 45 put. To realize our maximum profit we need the stock to be above $45 at expiration. Using delta we can calculate the probability of the stock residing above $45, thereby calculating our probability of profit. The current delta of the 45 put is .30, implying the stock has a 30% probability of residing below 45 at expiration. We can plug this delta (.30) into our formula: 1 - .30 = .70. In addition to knowing the risk-reward of the 45-40 spread, I now know the likelihood of realizing my profit is 70%.

For other posts on delta, check out:

Stay tuned for Part Two...

Wednesday, October 7, 2009

Playing with Semis

To exploit the expected neutral to bearish move in SMH, suppose we want to sell an OTM call spread. In choosing which strikes to use I usually go as far OTM as possible while still receiving sufficient credit. My target is usually in the neighborhood of a 15% return. For SMH, the November 27-30 call spread seems to be the right fit for me.

Sell Nov 27 call for $45
Buy Nov 30 call for $.05
Net Credit = $.40
Max Risk = $2.60
ROI = $.40/$2.60 = 15%

[Source: EduTrader]

Let's tackle a few potential questions:

Why a $3 spread? why not a $4 (27-31) or $5 (27-32) spread?

Remember, wider spreads have more potential risk, so if I'm going to widen the spread between the strikes I need to make sure I'm justly compensated. Had I bought the 31 call instead of the 30, I would have only increased the net credit by about $.03. Is it worth increasing my risk by $1.00 if all I bring in is another $.03 of premium? Absolutely not! Now, using the same rationale I may have considered doing a $2 spread (27-29) instead of the $3 spread I highlighted (27-30). It comes down to personal preference and risk tolerance. Bottom line- if you're going to widen the spread between strikes make sure it's worth it!

Why November? Why not use October or December expiration?

Given that October expiration is next weekend, there isn't sufficient premium in Oct. OTM calls to make it worthwhile. In addition I prefer to avoid holding options close to expiration if I can avoid it. This helps to minimize the gamma risk in the trade.
I also prefer the higher rate of time decay inherent with November options vs. December.

For other call spread posts, check out:

Semiconductors: A Technical Perspective

Identifying a potential top in this powerful uptrend has been harder than nailing jello to the wall. Although I'm fairly adept at technical analysis, my ability to forecast price direction isn't nearly as good as what I'd like it to be, which is undoubtedly why I prefer higher probability option trades such as condors, naked puts, etc...

Suppose I'm of the opinion that last week's sell off is a sign of more weakness to come. If I wanted to start searching for potential bearish plays I'd consider the following in trying to stack the odds in my favor:

1. Find a relatively weak sector or stock
2. Enter a higher probability bearish strategy such as an OTM call spread
3. Scale in

Of the various sectors I follow, Semiconductors have begun to show some chinks in the armor.

Take a look at the weekly chart (click image to enlarge):
[Source: EduTrader]

26.50 was a strong support level between 2004 and 2008. Once broken, the SMH took a swan dive towards the mid-teens. Now that it has been successful in retracing all the way back up to its breakdown point, one would assume there is a plethora of overhead supply which should make it tough for the SMH to continue its rapid ascent.

A quick glance at the daily chart gives a more refined perspective as to what has transpired recently..
[Source: EduTrader]

1. Slowing Momentum- Each successive breakout has experienced diminishing follow through showing a lack of strength from the bulls.
2. The large selloff experienced by the market on Oct. 1st resulted in a break of support and the 50 MA.
3. Higher volume accompanied the sell-off showing large participation in that day's selling.
4. The MACD is showing divergence, further verifying the slowing momentum mentioned earlier.

Based on the above, a technician could make a pretty good case for more weakness to come within the semis. The obvious caveat emptor is the fact that the market is been a veritable freight train disregarding each and every sign of a top thus far.

Next post I'll review a bear call spread on the SMH.

Monday, October 5, 2009

Lauding the Accomplishments.... or Lack Thereof

Investigation of an Over-Write

Last Thursday's post reviewed the current status of a GLD strangle. Let's follow that up by reviewing the current status of a trade mentioned way back in the Aug 31st post on Over-Writing.

At the time, National Oilwell Varco was trading around $36.50 and I mentioned selling the Oct. 40 call for $1.50. The risk-reward characteristics of the trade are listed below.

NOV Over-Write
Cost Basis: $36.50 - $1.50 = $35.00
Max Risk/Breakeven: $35.00
Max Reward: $40- $35.00 = $5.00
ROI (if assigned) = (5/35) 14% return
ROI (if stock unchanged) = (1.50/35) 4% return

Risk Graph @ Trade Inception (click image to enlarge)
[Source: EduTrader]

Current Risk Graph (click image to enlarge)
[Source: EduTrader]

NOV is currently trading at $41.90. The Oct. 40 call is currently trading around $2.70. Remember, the $2.70 is comprised of both intrinsic and extrinsic value. Given that the current price of NOV is $41.90, the 40 strike call possesses $1.90 of intrinsic value and $.80 of extrinsic value.

With NOV residing above 40 and inside of our max profit zone, the trade has worked out fairly well thus far. What are the potential actions worth taking (if any) at this point?

1. Do Nothing. If we anticipate NOV staying above $40, we could merely sit on our hands and ride the trade to expiration in an effort to realize the maximum profit. Remember, because we're obligated to sell NOV at $40 a share, the stock will be taken away over expiration weekend if it resides above $40. Although we've already accumulated a $420 unrealized gain of the possible $500 gain, there is still another $80 of potential profit. That $80 represents the amount of extrinsic or time value remaining in the call option.

2. Exit Trade to Lock in Unrealized Gains. Given that we've already accumulated the majority of the potential profit, we could choose to fore go the last $80 by exiting the trade now. This would eliminate any chance of giving back our gains due to a significant drop in NOV price between now and expiration.

3. Roll Forward. If we like the prospects of NOV going forward and wanted to enter another covered call for November, we could buyback the Oct. 40 call and sell a Nov call option, such as the 42 or 43 strike.

Like any trade, there isn't one right way to manage the position. It comes down to risk tolerance, personal preference, market outlook, etc...

For other posts on Over-Writes, check out: