Monday, September 27, 2010

We're Moving!

As the two year anniversary approaches for my writing ventures here at blogspot, I've decided it's finally time to bust a move.  While blogspot has treated me well, there have always been a few features, or lack thereof, that have curtailed my creativity and hindered my ability to deliver content in the manner I want.  Moving to a more robust web hosting platform will help overcome these nuisances while giving Tyler's Trading more room to grow in the future.

Regarding location, is simply becoming www.tylerstrading.comI've now saved you time by shaving nine characters off my url.

I know.

You're welcome.

The new site is still a work in progress and you will likely see continued changes to come.  I plan to post any new content going forward within the new site versus here at blogspot.For those of you that have links to my site, please change the address to

Those subscribing to my RSS feed will need to change your subscription to the new site.  You can either head to the site and click the RSS feed icon (top right corner) or use the following link: Tyler's Trading RSS Feed.

If you see any issues or bugs that need addressed, pipe in the comment section or shoot me an e-mail:

Thursday, September 23, 2010

Low Volatility, a Siren Song?

With the VIX residing close to its lowest levels in half a year, talk of buying volatility is coming back in vogue.  While the appeal of loading the boat with long volatility strategies is understandable, be aware that this particular temptation may turn out to be a siren song.
In Greek mythology, the Sirens were three dangerous bird-women, portrayed as seductresses who lured nearby sailors with their enchanting music and voices to shipwreck on the rocky coast of their island... The term 'siren song' refers to an appeal that is hard to resist but that, if heeded, will lead to a bad result.
In the world of volatility, traders would be well served to remember that everything is relative.  Though a VIX at 22 seems cheap compared to its recent range, keep in mind the following two things:  First, the historical mean of the VIX resides right around 20 which, at the least, should make traders rethink how cheap 22 really is.  Second, and perhaps more important, the only volatility that truly matters is how much the underlying stock actually realizes throughout the duration of the trade.  And, if current market volatility is any indication as to what the future holds, not only is 22 not cheap, it's arguably expensive.

Suppose we heeded the low volatility call and purchased Oct 113 straddles on the SPY.  At a current implied volatility of 20%, the straddle is pricing in roughly a 1.26% move per day.  For those disinclined to take the percentage route, that comes out to an expected daily move of about $1.42 (roughly 2/3 of the time).  In addition, this also means we should see the occasional move in excess of $1.42 (roughly 1/3 of the time). Unless you've had your head buried in the sand, you should know we have most definitely not experienced that type of movement in recent weeks (see 10 or 21 day historical vol). 

In sum, despite the ostensibly low volatility, straddle buyers still seem to face an uphill battle.  Unless you're of the opinion that either the market movement is poised to increase notably in the coming weeks or we're on the verge of a strong directional move, straddles are not a slam dunk buy here in my humble opinion.

For related content, readers can check out:
The Tempest and Volatility Analysis
Straddles and Gamma Scalping
Gamma Scalping Inquiry
Implied Vol vs. Historical Vol

Tuesday, September 21, 2010

The Oil Angle

After spotlighting the relationship between precious metals in yesterday's The SLV Lining post, today marks yet another foray into the commodity space in an attempt to draw some meaningful conclusions. Whether it is due to my recent fixation on relative comparison charts or my monthly option plays on the United States Oil Fund (USO), I've noticed oil has been riding the pine for much of the recent bull run.  In Monday's Chart of the Week, Bill Luby of VIX and More cited the broad-based support for the market rally as virtually every  market sector was experiencing notable gains.  The same could be said regarding commodities for that matter.  In addition to the aforementioned silver and gold, we've seen a variety of agricultural commodities climb on board the bull boat as well.

So what's the deal with oil?  Not only is it not on board, it's floundering in the water unable to catch a bid.  Consider the following relative comparison chart (click to enlarge).

[Source:  Livevol Pro]

While USO did a commendable job in tracking the performance of both the SPY and GLD through the month of April, from May forward it seems to have lost its mojo.  Despite the apparent weakness in the underlying commodity, it may be important to note that most energy stocks have fared much better over the same time frame.  Both the Energy Select Sector SPDR Fund (XLE) and Oil Services HOLDRS Trust (OIH) have had much better participation in the recent rally in the equities market.

For related content, readers can check out:

Monday, September 20, 2010

The SLV Lining

With last Tuesday's breakout to all time highs, gold was thrust back into the spotlight after receiving little attention over recent weeks.  Though gold is usually the primary recipient of media attention within the commodity space, silver has been capturing some significant gains as well.  Indeed, silver, as measured by the ishares silver trust, has tripled the gains of gold over the past month (click image to enlarge).

[Source: Livevol Pro]

To exploit a continued rise in silver, how about this short put, long call spread combo suggested by the IVolatility Trading Digest Blog:

With a Historical Volatility of 18.54 and an Implied Volatility Index Mean of 29.33 for an IV/HV ratio of 1.58 and a very bullish put-call ratio of .24, consider this combination.
 In the event there is a correction in the next few weeks, there is a chance the Oct 20 put will be in-the-money and assigned.  This could be part of a plan to establish a long ETF position. In the event there is no near-term pull back then the October will expire reducing the cost on the outstanding long call spread.  However, if the correction continues back below 19, then consider unwinding.
All in all I like the structure of the play.  I'm a fan of using short puts on cheaper priced stocks particularly when one is seeking to accumulate shares of stock at a discount.  The long call spread goes out a couple months giving traders ample time for the stock to move into the meat of the spread.

For related content, readers can check out:
IVolatility Trading Digest Blog

Friday, September 17, 2010

Volatility Comparison Charts

In Livevol's newest round of software updates, they've launched yet another groundbreaking tool for option traders.  While perhaps not as revolutionary as their 3D Skew feature, the new volatility comparison charts still offer some exciting possibilities.  Though there are numerous sources you can go to that offer the ability to compare historical and implied volatility for the same security, I'm not aware of any, save Livevol, who offer the ability to perform relative comparisons on the implied volatility of different securities.  While it's true you could view multiple volatility charts side-by-side or one after the after the other to make relative comparisons, Livevol has taken it a step further allowing users the ability to overlay vol charts from several different securities simultaneously.  Consider the following chart comparing the 30 day implied volatility of RIMM versus the SPY (click image to enlarge).

 [Source:  Livevol Pro]

As I see it, viewing vol charts in this manner gives us the ability to draw quicker, more meaningful conclusions in the area of correlation.   Traders can now easier tackle questions such as...
What effect do broad market volatility trends have on the volatility of individual companies?
What are the similarities or differences between the volatility of different asset classes such as stocks, bonds, and commodities?
When do we see an individual company's volatility move in tandem with the VIX, when does it move to the beat of its own drum? 

In addition to the aforementioned volatility comparison charts, other new features of note include relative price comparison and a custom scanner allowing the ability to build scans specifying your preferred price, volume, fundamental, and volatility characteristics.  When launching Livevol Pro, it was professed "to be the new standard in option trading".  Well, mission accomplished in my book.  It is quickly becoming a one stop shop for option analytics.

For related content, readers can check out:
What Will They Think of Next?
Finding Volatility
GOOG, What Volatility Bid Up?

Wednesday, September 15, 2010

It's Settled

 Traders owning any type of bullish position going into today's VIX expiration woke up to a pleasant surprise.  Since assessing the volatility landscape in last week's The Impending VIX Expiration post, we've seen a heavy VIX continue drifting lower day by day. However, this morning's pop erased the losses of the past few days lifting the fear index up towards last Thursday's price levels.  We all know (hopefully) that settling VIX options can get a little squirrely.  Though I outlined a fairly systematic method for analyzing volatility, there is a bit of luck involved with getting a favorable settlement value.  Keep in mind however, for as many settlements that move in your favor, you will likely have an equal amount where you get shafted.  Of course, some choose to simply forego all the drama unfolding around settlement by exiting their positions beforehand.

Per the $VRO chart below, September's official settlement value came out to 22.97.  At $1.41 higher than yesterday's close and $.42 higher than this morning's opening print on the VIX, settlement certainly tilted in the favor of the bulls (click to enlarge).

[Source:  MachTrader]

For related content, readers can check out:

Tuesday, September 14, 2010

Stealth Rally

While the S&P 500 has been riding on the seemingly endless 1130-1040 merry-go-round in recent months, gold has staged a stealth rally.  Since the middle of July, dip buyers largely disenchanted by the seesaw action in equities have been welcomed with open arms by the shiny metal.
[Source:  MachTrader]

As a result of this virtually uninterrupted march higher, historical volatility has tumbled off a cliff to its lowest levels in years (8%).  Not that this is all that revealing, as just about any steady uptrend is accompanied with declining volatility.  At the same time implied vol is reticent to drop below 16% which has acted as a consistent floor over 2010. 

[Source:  Livevol Pro]
In addition to the SPDR Gold Shares shown above, we're also seeing the Market Vectors Gold Miners ETF (GDX) pop to new all time highs.  Suffice it to say, those that have stuck with the gold trade are certainly reaping their rewards.

For related content, readers can check out:
Gaming the Gold Bugs Redux

Monday, September 13, 2010

I've Got That Contrarian In Me

Given the deluge of bullish activity over recent weeks, we've seen the market traverse its entrenched trading range yet again.  Practitioners of technical analysis placing significance on support and resistance levels would assert the markets are quickly approaching a critical juncture.  Ever since the aftermath of the May Flash Crash, 1130 has acted as the proverbial ceiling in the sky curtailing each bullish advance.  Whether you argue that past is prologue and expect the bulls to once again be rebuffed, or expect this particular test to yield different results, it's tough to deny the low risk/high reward entry being proffered by Mr. Market for bearish trades.

Take the SPY for example. If your exit point sits right above resistance you're looking at about $1 to $2 risk.  Now, as for the target, I'd say bare minimum a one Average True Range drop could be in the cards.  Setting the bearish sights higher (or lower as it were), who's to say the market couldn't return back towards the lower end of its range (click image to enlarge)?  
[Source: MachTrader]
With volatility sitting at its lowest levels since before May's fireworks, we could make a compelling case that buying options may not be a bad idea around here.  So, how about entering bearish risk rocket by shorting some stock and buying puts?  Consider the following example:

For related content, readers can check out:

Friday, September 10, 2010

The Dynamics of Time Decay

When asked how to define Theta, the textbook answer is it allows traders to measure how much money an option position will make or lose per day. Though that may be adequate for an elementary understanding, there are many questions that arise when considering how time decay plays out in the real world where weekends and holidays are interspersed throughout an options life.

Having never been a market maker and never needed to generate quotes for options on a day to day basis, I must admit my understanding of the finer nuances of how time is calculated into an option's premium is certainly not as exhaustive as some. So when I received the following thoughtful question from Bill, I passed it along to Mark Wolfinger of Options for Rookies to take a stab at. Rather than post the original question, which was rather lengthy, the gist was as follows:

How does the options market account for weekends and holidays when pricing in time decay? Do options lose value over the weekend or has the weekend decay already been priced in by the close on Friday? If that's the case, does that mean options lose more value toward the end of the week relative to how much they're losing at the beginning?

The Black-Scholes and other formulas that calculate the value of an option use time as an important consideration. Time is defined as the number of days (hours, minutes, seconds, or whatever unit appeals to you) until expiration arrives. Thus, yes, you can be certain that the weekend is included in the process that determines the value of an option.

But if your question is: Will I see that time decay every day - then the answer is 'no'. Market makers set their clocks - the ones used to determine the value of an option - any way they prefer. And they prefer accelerating time prior to a weekend. When you come in Monday morning, you will never see options priced as if 3 days just passed. That decay - most, almost all, or all, has already been priced into the price of the options at the end of the prior week.

There is no set formula. Each market maker, specialist, and off-floor market maker, is free to establish his/her own program that determines the value of an option - and thus the bid/ask quote. Anyone who believes a big error has been made in the option price is free to sell the bid or pay the offer to take advantage of that 'mistake'.

[Note- This is part of the question] When I look at option pricing, there are too many factors influencing the price for me to tell the EXACT effect of theta over the weekends.

And you can never see the exact effect over the weekend. Why? Because of the way that options are priced. Each market participant gets to move the clock at whatever rate he/she sees fit. They set the bid/ask and you can trade with them, make higher bids or lower offers, but you cannot tell them how to set the clock. And the truth is that you can never know if a small change has been made to the volatility used to calculate the theoretical option values.

One simple plan is to have the clock move 7 days over the 5-day week. A more reasonable approach is to move the clock 7 days over the 5-day week, but with time accelerating during the week. Thus, it would pass much faster on Friday than on Monday. More than that, each day is not consistent, and time would pass more rapidly in the afternoon than in the morning - steadily accelerating throughout the week.

Other traders may use an algorithm that allows some passage of time over the weekend. Why? Although there is no trading, events happen, wars begin etc... Just allowing for a market-moving event makes sense. But just how much of the one week's worth of time does one devote to the weekend? I have no answer, but there's big money at stake and my wager is that the methods used to determine the clock algorithm for each trader group is a closely guarded secret.

If you take the time to look at the numbers, you will discover, all things being equal (quiet news weekend and a flat opening) the options open where they closed. There is no big price drop. In fact, it's possible for options to move up a bit in price to counter the effect of over-discounting them on the previous Friday.

For related posts, readers can check out:
Gamma vs. Theta Part I
Gamma vs. Theta Part II

Thursday, September 9, 2010

The Impending VIX Expiration

It's that time again...

Each month as expiration approaches, I habitually seek out any potential short term plays using VIX options. In identifying whether or not I have a strong enough bias worth acting on, I typically consider the following data:

Recent realized volatility of the SPX via 21 or 10 day historical vol.
The posture of the VIX index - are we close to an inflection point?
A comparison of the level of the front month future set to expire (Sept. in this case) vs. the VIX index. Is there still a notable discrepancy between the two? How much?
What option strike prices are still in play and do they offer sufficient premium to construct a position?

The underlying rationale for sticking to VIX option plays close to expiration is the increased correlation between front month futures and the Index. The higher the correlation between the two, the greater my confidence level that the futures will follow my forecast on the Index. As stated numerous times in the past, this increased correlation is driven by the fact that VIX futures converge to the Index at expiration.

So what's the current landscape look like?

Both 10 and 21 day historical volatility on the S&P 500 Index reside just north of 21%'
The VIX Index is nestled pretty close to its lower bollinger band at 22.3% - tough to say whether we're at an inflection point yet, but I would lean toward being more bullish than bearish.
Sept. VIX futures are sitting at 23.8; at a 1.5 premium to the Index, futures players are still expecting a minor increase in the VIX before next Wednesday's expiration.
If I wanted to opt for selling put options, the 22.50 ($.35 by $.40) or 24 ($1.20 by $1.30) are the two closest to the money.

[Source: MachTrader]

While the 24 strike put is a little too close for comfort, the 22.50 is lacking adequate premium. I'd prefer to see a further dip in the VIX causing the 22.50 to rise in value closer to $.60 or so. At that point, shorting puts starts to attract my attention.

For related content, readers can check out:
VIX Expiration and Term Structure
Settlin' Them VIX Options
VIX Options

Wednesday, September 8, 2010

Condor Evolution

In yesterday's post, I explored the role negative gamma plays in the evolution of a condor position. When displayed within a risk graph, it becomes readily apparent why condors thrive when mean-reversion drives market conditions. Yet another feature which helps explain a condor's frequent transformation from a non-directional to directional play is the inherent structure of the position.

The iron condor involves selling an out-of-the-money call and put spread simultaneously. Generally the deltas of each vertical spread offset each other bringing the net position delta close to neutral. In an ideal world, the stock would remain directly in between both spreads as time decay whittled away at their value. Both spreads may even approach their profit targets at similar speeds allowing you to exit the entire condor all at once. Unfortunately it rarely plays out this way in the real world. Typically the stock rises or declines affording the ability to close one side of the condor early - the put spread if the stock rises, the call spread if the stock falls.

Upon closing the winning side of the condor, trader's are left holding a directional vertical spread. When selling condors in a bullish trending market, they will likely turn into short call spreads before too long. On the other hand, when selling condors in a bearish trending market, they will likely turn into short put spreads.

In sum, though you may initiate a condor indifferent as to which way the market moves, you will quickly develop a directional bias due to the manner in which a condor changes its personality.

[Evolution Pic by Thomas Wizany]

Tuesday, September 7, 2010

The Case for the Condor

While the successful bullish defense of the 1040 level may have been met with derision from directional traders and anyone looking for a continuation of August's downtrend, there were no doubt traders who welcomed the bounce off of 1040 with open arms. Those positioning themselves to profit from range-bound action likely feel anything from calm satisfaction to extreme exhilaration on each successive failure of the bulls and bears to bust out of their range-bound prison.

We're running on about four months of ping pong action between the 1130 and 1040 key price thresholds. One of the aforementioned satisfied parties are condor traders. Condors excel in range-bound, declining volatility environments, which sums up the majority of the last few months. Though the condor initiates its profit seeking existence with a delta neutral, non-directional type personality, it can quickly become a directional player. This is due largely to its negative gamma nature.

The negative gamma aspect of condors has the effect of getting you shorter the market as it rises and longer as it falls. While this type of behavior shines when mean reversion rules the day, in trending environments where weakness begets more weakness, getting longer into dips that keep on dipping can be quite painful. Within a risk graph, delta neutral negative gamma positions, such as the condor, show up as an upside down parabola (click image to enlarge).
[Source: MachTrader]

In later posts, we'll flesh out a few more details on our flying friends.

For related content, readers can checkout:
Strangles vs. Iron Condors
Saved By The Wings
Gamma Facts

Friday, September 3, 2010

Call Spread Conversations

I received a question regarding call spreads in response to last year's Above the RIMM post. Since I've heard variations of the same question over the years, I thought it might be beneficial to outline my response in today's post.

...What I didn't really contemplate with call spreads is the time value. Let's say RIMM closes above the strike that you sold the very next day after you put on the trade. You don't reach or even come close to you max. profit do you because the trade still has time left before expiration. This seems to be the case which says to me the gain you would have would be so dismal you might as-well let the trade go on for a few weeks if its a front month contract, in order for time value to decrease.

It seems as though if I'm looking to day trade/swing trade then call options are really my best choice rather then spreads because my profit would look much better over just a day or two on the trade...

You're pretty much on track regarding how long call spreads progress. Since reaching their maximum value requires all of the extrinsic (time) value to bleed out of the option, you either have to wait until expiration or have the call spread move deep enough in-the-money until the calls are trading close to parity. So, while it's not impossible to capture the bulk of your rewards in just a few days, it's rare. If you desired to accelerate the progress of a call spread, you could simply use shorter dated options versus longer. For example, if you purchased a one month call spread versus three months and the underlying stock moved through the spread, the front month spread would rack up gains quicker.

Now, as to whether the gains will be "dismal" really depends on the magnitude of the move in the underlying stock, which expiration month you're looking at, and how many contracts you have in the position. Suffice it to say, long call spreads are not the most efficient, nor effective way to exploit short term moves in a stock. So, in that regards we are in agreement.

However, just because a long call spread isn't the most effective vehicle doesn't necessarily mean that buying call options is the "best choice" for day/swing trades. Honestly it's difficult for anyone to say what is or isn't the "best choice" as it varies from trader to trader depending upon what you're trying to accomplish. Due to the inherent trade-offs which all the option strategies the "best choice" will inevitably vary from situation to situation. If your goal was to swing for the fence by accumulating a high delta position, then I can see the allure of trading call options. Just keep in mind, they can be quite unforgiving when you're wrong.

Though purchasing call options is much more effective than call spreads when day trading, I think there are superior alternatives in the day trading arena. Since day traders are playing smaller moves in a stock, they need higher delta positions that rack up profits quick. In that regard, futures and stock are more effective. The other issue that arises with options is the wider bid/ask spread. While that may not present much of an issue if you're doing a longer term trade, it can create a large problem when day trading because you're typically playing very small moves in the stock.

For related content, readers can check out:
Call vs. Put Spreads
Call Spreads and Assignment

Wednesday, September 1, 2010

Volatility Spankin'

Due to the recent victory of the bulls in defending the 1040 level coupled with this morning's flurry of bullish activity, volatility is tumbling down from its lofty levels. Since highlighting the somewhat extreme vol levels that had arisen in last Wednesday's Fading Away post, we've seen a notable decline in the VIX to the tune of 16%. Over the same time frame, we've also seen the VXX down around 12%. This obviously bodes well for those who took last week's volatility surge as an opportunity to enter short volatility strategies. The suggested 1x3 SPY put ratio spread has not surprisingly fared quite well in this environment. In addition to the declining volatility, we've also experienced a week of time decay and a mildly bullish move in the SPY - a trifecta of positive events accelerating our profit accumulation. The current status of the spread is displayed below:

[Source: MachTrader]

The spread was originally sold for a $.95 credit and can now be exited around a $.15 debit. This particular play is not unique in its performance this week. The majority of short volatility strategies I consider when vol is high would have delivered this go around.

For related content, readers can check out:
Entering the Volatility Fray
Exiting the Volatility Fray
Ratios, Ratios, and more Ratios

Tuesday, August 31, 2010


In continuing with the technical analysis theme laid down yesterday I wanted to make a few observations regarding the state of the S&P 500 Index. It strains the obvious to point out the significance of the 1040 level over the past year. Disregarding the short lived breach in July, it has held steady as a key line in the sand denying bearish advances time and time again. As the market action has become more and more erratic in recent days, it's been interesting to watch the interplay between the bulls and bears surrounding this pivotal level (click image to enlarge).

Source: [MachTrader]

Notice the sharp rallies quickly following each bearish attempt to breach this support level.
Were we to view these skirmishes using the SPY coupled with volume, you'd also notice a sizable amount of volume rising up during these engagements. Suffice it to say, the bulls are proving quite resilient and quick on the trigger in defending their turf. However, with each additional attempt at cracking this level, the resolve of the bulls is likely fading.

When and if the bears finally succeed (I'm in the "when" camp for what it's worth), this demarcation line will stand as yet one more victim, albeit the largest to date, to the current deterioration of the market.

For related posts, readers can check out:
On the Brink
Lines in the Sand
State of the Market

Monday, August 30, 2010

It's All Relative

In sizing up the equities landscape, one tool that has proven indispensable is a relative comparison chart. While one can usually determine the strength or weakness of various slices of the market simply by assessing sector and industry ETF's, it can prove rather cumbersome to sift through each chart individually. Relative comparison charts not only provide a quicker, more simplistic alternative, they often offer up the data in a manner which allows more meaningful conclusions to be drawn.

In the past I have used the simple charts offered within Yahoo! Finance's website. However, since catching wind of the impressive free tools offered at (hat tip Bill Luby), I've spent the bulk of my relative comparison efforts there. If we wanted to determine which major US sectors have been leading the downturn over recent weeks we could select the sectors in question and view how their performance has stacked up. The following chart displays the relative performance of the technology, energy, financial, consumer discretionary, and materials sectors over the past month (click image to enlarge).

Source: []

Within this time frame, Financials have been the notable underperformer. If you subscribe to the notion that weakness begets weakness, you'd probably be well served by avoiding bullish trades in this sector and perhaps looking instead for bearish plays.

For related posts, readers can check out:
A Primer on Relative Performance
Comparing Apples to What?
Chinks in Small Cap Armor

Wednesday, August 25, 2010

Fading Away

The recent sell off in the equities market has ushered in yet another uptick in fear. During the past few weeks, the CBOE Volatility Index (VIX) has surged over 30%. While the increase in pessimism and insurance premiums may have investors cursing the market, you can bet volatility traders are looking at this as a visit from good ole' Mr. Opportunity once again coming to knock on their door. These traders are likely taking a contrarian viewpoint by seeking opportunities to fade the volatility extremes that have recently cropped up.

So, how might those who have been bit by the contriarian bug go about gaming some mean reversion in volatility? Well, take your pick. Nowadays we've got a smorgasbord of volatility products to play with. You could dabble with bearish plays on the VIX or VXX; or perhaps try out the newer inverse volatility product- the XXV. Of course, since the VIX is simply a reflection of implied volatility on S&P 500 options, you could try your hand using options on the SPX or SPY which afford bearish volatility exposure such as short put spreads or put ratio spreads.

Traders electing to take the S&P option route also need to consider their outlook on the underlying Index as it is possible to enter short volatility plays that provide either bullish, bearish, or neutral exposure. One of the strategies I've mentioned in the past which profits from a decline in implied volatility as well as neutral to mildly bearish movement in the underlying is the put ratio spread.

Suppose you purchase the Sept. 100 put for $1.15 while simultaneously selling three Sept. 97 puts for $.70 apiece. The net credit comes out to $.95. Consider the risk graph below modeling the effect a drop in implied volatility has on the PnL of the position (click image to enlarge).

Tuesday, August 24, 2010

Rolls... Fresh Out the Oven

Owning profitable positions always presents a dilemma of sorts. When things are going your way, do you double down and press the issue or ease off the gas a bit and exercise caution? In the past I've continually touched on the fortes of adjusting a position to reduce risk and potentially lock in gains. This provides a palatable alternative to those desiring to proceed with caution yet not wanting to completely close their position. Utilizing the bear playbook highlighted in yesterday's post, let's highlight one such example.

Suppose after the SPY broke below the 50 MA earlier this month you decided to up the ante on the bear side by actively seeking out low risk high reward trade setups. The retracement that occurred from 8/16 to 8/18 presented just such an opportunity. Let's say we purchased two Oct. 110 puts for $4.91 ($9.82 total) to exploit the anticipated sell-off. Given the recent bearish extravaganza, the put options have increased in value to $6.65 yielding a tidy $1.74 profit ($3.48 total). Consider the current status of our position illustrated below (click image to enlarge):

[Source: MachTrader]

Rather than staying the course or increasing our bets, suppose we take this morning's bloodbath as an opportunity to lighten up a bit by rolling our long puts into put spreads. We could sell two Oct 105 puts for $4.02 ($8.04 total) effectively morphing our position into a long put spread. Consider the updated position taking note of the overall change in risk and reward:

Though we've cutoff our unlimited profit potential, we still have the ability to double our current profits. We've also succeeded in dropping our risk capital from $982 to $178. Those actively playing with puts would be well served by familiarizing themselves with the advantages or rolling to spreads.

On a side note, the current surge we're experiencing in volatility maybe close to setting itself up for yet another fade.

For related posts, readers can check out:
Rollin with My Puts
Hedging with Calendars
Adjustment Thinking and the Salvation Syndrome

Monday, August 23, 2010

What's the Game Plan?

Over time traders are exposed to varying trading styles and strategies. While one could attempt to utilize every technique, most settle into a consistent routine with a few favorites. Though there are a variety of factors that ultimately influence which trading style trader's adopt, identifying one's niche boils down to personal preference, risk tolerance, and what I would call the success factor. I suspect most traders, like me, gravitate towards those strategies which consistently deliver. In other words, we use the strategies that have proved the most fruitful in the past. If it's a trading technique that fails to deliver after multiple attempts, I'm not afraid to toss it in the thanks but no thanks bucket and move on. While I'm always on the look-out for new ideas, I'm not on a quest to clutter my toolbox with unworthy, fruitless strategies.

I'm continually tinkering with better ways of organizing my play book. One preferred approach is to break it down into trade setups and strategies of choice. The graphic below displays my current method of choice for arranging my bear toolbox. I've not only identified the trading patterns of choice, but also the strategies used to exploit these trading opportunities.

The end goal and ultimate litmus test for any market participant is consistent profitability. Reason will tell you consistent results necessitate a more systematic, structured approach. If you're lacking structure, consider today's post just one idea of how to begin the process.

Tuesday, August 17, 2010

Expiration and the Resolution of our VIX adVentures.

This morning's opening prints ushered in the settlement value for August VIX options. While the VIX opened at $24.30, settlement came in a bit higher at $24.82 (click image to enlarge).
[Source: MachTrader]

In last week's Tale of the VIX and Mr. Upper B., we outlined the antagonistic past between these two foes, noting their inability to reside in the same place at the same time for extended lengths of time. The Fear Index once again followed the fairly predictable path of least resistance by retreating to its turf in the "meat" of the bollinger bands. While a continued sell-off in equities may cause yet another run-in with the upper bollinger band over the coming weeks, the ebb in fear experienced over the past few days was sufficient to deliver a winner for the suggested bear call spread.

By settling in the 23 to 24 area, our 27.50 - 30 bear call spread expired comfortably out-of-the-money. Those unwilling to brave all the settlement drama could have simply closed the spread yesterday at $.05, thereby locking in the majority of the gain.

For related posts, readers can check out:
Fading Complacency
VIX Expiration and Term Structure
VIX Options Laid to Rest as the Cash Springs to Life

Monday, August 16, 2010

Rough Seas Ahead?

In July's trio of posts, The Nifty Fifty, The Effectiveness of the 50 MA, and It Was the Best of Times, It Was the Worst of Times, I explored using the 50 day moving average to generate intermediate term long/short signals on the SPY. Though it experienced the occasional whip-fest , it proved quite beneficial over the long run. Due to the trending nature of 2010, the 50 MA has done a commendable job in positioning its followers on the right side of the trend thus far.

With the recent weakness in equities, we've seen another potential sell signal based on the 50 MA. The reason I say "potential" is because it really depends upon your filter. In outlining the initial strategy I mentioned we want to see a break of 1+% of the 50 MA before declaring it an official break. The idea is to avoid whipsaw by flipping your position too frequently based on noise. Given that the most recent 1% probes below the 50 MA have occurred during the opening of the market on sizable down gaps that have been immediately bought up, I'm biding my time before I call this a genuine sell signal.

[Source: MachTrader]

If another April to July type downdraft is in the cards, those heeding the most recent break of the 50 are going to be well-rewarded. On the other hand, if the SPY quickly reclaims the 50 MA and we turn into sideways chop city, this particular signal may not turn out as lucrative as some of the others in the past.

Friday, August 13, 2010

The Tale of the VIX and Mr. Upper B.

After a six week absence, the VIX has once again decided to pay a visit to its dear old friend Mr. Upper Bollinger. On the tails of a rapid two day 4% plunge in the S&P 500 Index and the constriction of Bollinger Band width, the encounter shouldn't be that surprising to those monitoring the touch and go relationship between these two pals.

Come to think of it, perhaps I've got part of this metaphor all backwards, as these two completely inanimate variables which I'm so heartily trying to anthropomorphize aren't so much friends as they are enemies. It seems they are hardly ever comfortable residing in the same location at the same time. Matter of fact, with the recent exception of May, virtually all of their confrontations turn into short lived skirmishes ending with the VIX returning, often speedily, to its home between Mr. Upper and Lower B. Consider the following chart highlighting the last ten run-ins of these two foes (click to enlarge).

[Source: MachTrader]

With yesterday's exhaustion gap on the S&P 500 and subsequent pop in the VIX, might it be time to bet on a bit of mean reversion? Given the VIX's historical tendencies, it seems we have probability on our side. With August expiration for VIX options comin' round the corner, front month options lend themselves to some interesting short term plays. How about selling an Aug 27.50-30 bear call spread for $.50? Risking $2.00 for a $.50 payout over three trading days isn't too shabby in my book. Provided the VIX settles below $27.50 next Wednesday morning, both calls should expire worthless resulting in the realization of max profit. But, who am I kidding. I never ride to expiration so I'd likely bail upon capturing the majority of the gains.

Those convinced the VIX's little run in with Mr. Upper B is likely to linger would obviously want to pass up the play. On the other hand, if you think the market sell-off is due for a pause or perhaps a bit of a rally back, this may be a strategy worth considering.

For related posts, readers can check out:
VIX Options
Settlin' Them VIX Options
A Volatility Inflection Point
Lessons Learned From a VIX Put Matrix

Thursday, August 12, 2010

Viewer Mail - Long Call/Short Put Combo

Hey Tyler,

I'm long term bullish on TM and think most of their issues are over and they make a great product. What are your thoughts on selling some short term puts (Aug or Sept. 70) to help buy a LEAPS call like the Jan 2011 or 2012 75 or 80 strikes? I then could continue to sell puts each month against the call to generate cash flow?

Thanks, V-

Keep in mind buying a long term call option and selling puts are both bullish strategies. It's not as if the short puts are hedging your exposure on the call or anything. So, I would simply look at your idea as two different bullish strategies. By buying a long term call you're acquiring positive delta. By selling short term puts you're simply acquiring more positive delta. So it's inaccurate to say you're selling the puts "against" the long call. As to whether it's a good idea, it really comes down to how bullish you are.

If TM behaves as expected, then selling puts and buying the call will produce more profits. However, if TM drops in value you'll get hit on both the short puts and the call. Furthermore, the short puts open you up to unlimited risk. It's certainly a legit way to place a bullish bet, but just know there isn't necessarily any distinct advantage to combining a LEAPS call with short puts.

The more popular approach is to sell short term calls against the LEAPS, thereby acquiring negative delta and thus a partial hedge against your long call. This would simply be a calendar spread and works best in neutral to mildly bullish environments. Keep in mind long term calls are very sensitive to changes in volatility making it ideal to purchase them when vol is cheap. For what it's worth, TM implied vol does seem to be on the lower end of it's historical range. Here's a quick risk graph comparison of the two strategies (click image to enlarge).

[Source: MachTrader]

I'll point out two key differences and leave it to you to draw other conclusions. First, the position delta on the long call/short put combo is much higher (96 vs. 30), making it a more aggressive, directional bet. Second, while the calendar spread risk is $600, the long call /short put combo is unlimited.

For related posts, readers can check out:
The Oracle Calendar
The Oracle Calendar Part Deux
Naked Puts vs. Put Spreads

Wednesday, August 11, 2010

Hey Blockbuster, Eat My Dust...

... Love, Netflix.

Normally I don't get caught up in all the fundamental mumbo jumbo as it usually only takes me three minutes of looking at a balance sheet before I start to doze off. Charts, volatility, and market sentiment are more in my wheelhouse. But, I'd be lying if I said I haven't developed a great deal of curiosity with NFLX and it's veritable take-over of the movie rental industry. All it takes is one look at their stock chart to determine they've got some major mojo going on.

In a long line of goodies for the bulls, NFLX has delivered yet again:
Netflix Inc.has announced a deal, reportedly worth $1 billion, to bulk up its increasingly popular Internet streaming service with Hollywood blockbusters such as "Star Trek," "The Curious Case of Benjamin Button" and "The Godfather."

"What's exciting here is it really reaffirms that the Internet is a serious delivery channel," said analyst Colin Dixon, a senior partner for the research firm the Diffusion Group. Netflix has really been the catalyzing force on the market and it has illustrated very graphically that consumers are very comfortable consuming quality content directly from the Internet and in some respects, it's their preferred medium."

Published reports on Tuesday said the deal between Netflix, the Los Gatos firm that has built its business mailing rented DVDs to its subscribers, and Epix, a pay-TV service that is a joint venture between MGM, Lionsgate and Viacom Inc.'s Paramount, is worth $1 billion in licensing fees over the next five years.
One would have thought with the poor reaction to their quarterly earnings announcement on July 22nd, it may have been time for NFLX to pay the piper for their 400% gain over the past two years. Well, not so much. The good times continue to roll.

As is typically the case post earnings, implied vol may have put in a cyclical bottom last week making options a tempting buy. Due to yesterday's news and no doubt an uptick in demand for options we have seen vol pick up a bit.

[Source: Livevol Pro]
For related posts, readers can check out:
The Cycle of Implied Volatility

Tuesday, August 10, 2010

Stock Replacement Strike Selection

In Steven Sear's recent column How to Avoid Seller's Remorse, he expounds on some alluring advantages to the stock replacement strategy. One key takeaway is the drastic reduction in risk that occurs when one switches from stock to options. Yet another is the fact that options are relatively inexpensive right now given the VIX's steady decline toward the 21 level. I received a question regarding how one might go about selecting strike prices when implementing the stock replacement.

While there may be a few different tactics for deciding the optimal strike price, perhaps the easiest and most direct is to approach strike selection from a delta perspective. Since delta can be used to determine equivalent stock and option positions, it is particularly helpful when assessing which strike price provides the ideal outcome. Suppose you purchased 100 shares of AMZN at $122. Given its recent rise to $128, you're sitting comfortably on a $600 unrealized gain. In addition, your position's delta is +100. Suppose you wanted to replace your long stock position by purchasing a January 2011 call option. Consider the following two choices - a 100 strike call and a 140 strike call:

[Source: MachTrader]

While the deep ITM call costs more ($3200), you gain a higher delta (+84) making the position a closer equivalent to the shares of stock. Furthermore, the majority of what you paid is intrinsic value and will remain in the option so long as AMZN doesn't drop.
Though the OTM call is much cheaper ($730), you acquire a lower delta (+39). The ITM call was the theoretical equivalent of owning 84 shares of stock, the OTM call is the equivalent of owning 39 shares of stock. Since the call strike is 140, 100% of what you paid is extrinsic value and will incrementally erode away if AMZN doesn't rise past $140 by expiration.

In summary - if you want the call option to behave in a similar fashion to your stock position, buy an ITM higher delta option. If your focus is rather on reducing the amount of risk capital in the trade and you don't mind traversing the cheaper, lower probability route, consider OTM options. I suspect most traders reside somewhere in between.

For related posts, readers can check out:
The Replacements - As Good as the Original?
Stock Replacement Redux

Monday, August 9, 2010

Flys... of the Butter Variety

Let's take a brief stroll down memory lane to last Thursday. With the jobs report coming across the wires on Friday morning, the day prior would have been an opportune time to take some money, and perhaps more importantly, risk off the table. Particularly on positions that had behaved well and accumulated notable profits. The OIH bullish risk rocket outlined in last week's Bulls Bid-up Black Gold post may have been one such position, so let's walk-through a strategic adjustment.

The initial trade involved purchasing 100 shares of OIH at $107.35 and two September 115 calls for $1.95 apiece. The underlying rationale for the play was to exploit further upside movement in the oil services space based on the breakout of an ascending triangle two months in the making. The original risk graph is displayed below:

[Source: MachTrader]

While the OIH didn't rise high enough to reach our initial target of $110.35, it had accumulated enough profits to merit an adjustment. As previously explained in Evolution of a Bullish Risk Rocket, common adjustments for the risk rocket include rolling to a call spread, butterfly, or condor. Given the fact that I believe the odds of OIH breaching $120 by September expiration are slim, I opted to roll into the 115-120-125 butterfly versus a simple 115-120 call spread. Since the butterfly involves selling twice as many 120 calls it brings in a higher net credit thereby locking in more gains versus the simpler 115-120 call spread.

To fully grasp the drastic risk differential between the initial risk rocket with the post adjustment butterfly, consider things from a delta perspective. Due to the aggressive nature of the risk rocket, its position delta was relatively high at +160. Morphing to the butterfly reduced the delta to a mere +10. Even if OIH were to have the bottom drop out of it, the rate at which the position gives back profits has changed from being akin to an open fire hydrant to more of a leaky faucet.

For related posts, readers can check out:
Adjustment Thinking and the Salvation Syndrome
Risk Rocket
Rolling on the Fly

Thursday, August 5, 2010

Odds of Assignment

It's been awhile since I tackled some viewer questions, so here ya go:

I've been trading a calendar spread on VMW by selling short term calls against my Jan 2010 60 strike LEAPS call option. Currently I'm short the Aug 75 call option which has moved notably ITM due to the strong performance of VMW this month. Though the short option had about $400 time value a few weeks ago, it now only has $78. I've done this strategy for awhile and it has worked out nicely, but I haven't been faced with this dilemma. I don't want to close the position, nor do I want to be called out. Am I at risk of being called out? How?

Hey David,

Anytime I want to assess my odds of early assignment (you never really know for sure if it's going to happen), I consider three things: Is the short option ITM? Is it trading close to parity? Is the stock close to its ex-dividend date?

The first question is a no-brainer as no one in their right mind would exercise an OTM option. With VMW residing around $81.10, the Aug 75 call is certainly residing ITM. When we say an option is trading close to parity, that simply means it's trading close to its intrinsic value and possesses little to no extrinsic (time) value. As of this morning I'm seeing it trade for about $6.80. $6.10 of that is intrinsic value, the other $.70 is extrinsic. Based on the $70 remaining, I'd say your odds of assignment are still quite low.

Remember that option owners lose the extrinsic value when they exercise. So if someone owned the 75 call and exercised it, they would effectively be giving up the $70. Consequently, they are better off simply selling the call to close the position. Occasionally if the ex-dividend date is approaching and they want rights to it, investors may opt to exercise the call and buy stock. Thus, you may also want to consider whether an ex-dividend date is looming on the horizon.

Wednesday, August 4, 2010

Rhyme and Reason

Turns out my MasterCard pre-earnings analysis turned out to be spot on ... or not. Despite its historical bias towards rewarding volatility buyers and utter lack of volatility bid-up into earnings, MA still chalked up a win for volatility sellers. This go around the absence of any pre-earnings excitement turned out to be justified as the earnings reaction was a veritable snooze fest. With a mere 1.9% gap down, the reaction turned out to be the second smallest move over the past two years. I've updated the earnings table originally displayed in the For Everything Else There's MA post (click image to enlarge).

After all these musings on MA earnings, traders (including myself) may be wondering if their is really any value added to all the data mining. After assessing past earnings announcements and the volatility landscape, is one's ability to forecast the earnings move really improved? Well, consider the alternative. Suppose instead of the aforementioned educated approach, you simply flip a coin before earnings. Heads you buy volatility, tails you sell.

I gotta say my logic and reasoning rules in favor of the educated approach. Despite the fact that each earnings is unique and seemingly unaffected by past announcements, it is possible to identify a stock's normal price and volatility behavior around this event. I would submit this knowledge of the norm would improve one's chances of traversing the often treacherous earnings season.

Adam Warner of Daily Options Report posed a similar question in his cleverly titled Captain Kirk Dance Party Time. In regards to the accuracy of option expectations pre-earnings he states:

"So no, option players get it right at times....and also get it wrong.....and also pretty much scratch. It's a full range of outcomes.

Why bother looking then?

Well, I do like to see if we get some sort of pattern. Are high profile names getting "overbid" for the most part? If so, it presents some opportunities to net short options ahead of reports."

I like the analysis. The key is lies in identifying some sort of pattern. If one finds a discernible edge, exploit it. If things seem completely random, go golfing.

For related posts, readers can check out:
GOOG, What Volatility Bid-Up?
AAPL Options, A Steal or Too Rich?
The Relativity of Volatility

Monday, August 2, 2010

Bulls Bid-up Black Gold

Though equities were bid-up across the board in Monday's surge, the oil patch experienced notable relative strength. While there are a variety of charts I could cite to adequately display oil's bullish price action, I've settled on the Oil Services HOLDRs (OIH). Since imploding amidst the BP debacle in April and May, the OIH has formed a textbook ascending triangle over the past two months. With the successive higher lows as well as tight basing action in recent weeks, bullish footprints had already begun to appear prior to Monday's pop.

[Source: MachTrader]

When entering directional option plays I'm continually on the lookout for strategic entries to increase the likelihood of success. Of the plethora of bullish price patterns in the technical analysis realm, breakouts are one of my bread and butter. In anticipation of further upside in OIH, suppose I entered a bullish risk rocket by purchasing 100 shares at $107.35 and two Sept. 115 calls for $1.95 apiece.

With an ATR of $3, my initial profit target would be around $110.35. Upon reaching the target I could dump the shares of stock and roll the 115 calls to either a vertical call spread or a call butterfly. If executed correctly the adjustment should take the original risk capital off the table.

For those interested in more information on breakouts you can check out this short breakout video I drummed up from the archives. I posted it in early '09 just after starting Tyler's Trading.

For other related posts, readers can check out:
Christmas Musings and a Trade Journal
Fire Up the Boosters
Evolution of a Bullish Risk Rocket

For Everything Else There's MA

MasterCard is set to report earnings before the bell Tuesday morning. As I've mentioned ad nauseum, my default earnings bias is to short volatility as vol sellers typically have the upper hand. As with any set of stats, you always have your outliers bucking the trend. Looking at the data for MasterCard's last seven announcements, one could certainly assert it's one such outlier. In fact, it seems to be on a mission to punish short volatility players. Consider the following table outlining the earnings performance of MasterCard (click image to enlarge).

The Gap columns track the performance of MA from the prior day's close to the earnings gap open. The Straddle Value and Change columns track the performance of a front month ATM straddle from the prior day's close to the earnings day close.

Though it's granted three winners to vol sellers over the last two years, the rewards have been a paltry sum in comparison to the losses incurred by the four losers. Surprisingly, even the smallest short straddle loss (2/5/2009) was larger than the biggest winner (5/1/2009). Trader's habitually selling the pre-earnings vol ramp up may want to take this data as a note of caution for MasterCard. While short strangles or condors may have fared better, shorting straddles has not been a lucrative endeavor.

For related posts, readers can check out:
GOOG, What Vol Bid-Up?
Earnings Season Primer
Earnings... the Wrench in the Theta Clock

Thursday, July 29, 2010

It Was the Best of Times, It Was the Worst of Times

An in depth look at the SPY 50 MA Long/Short strategy in its best and worst years reveals its key fortes and failings. Of the ten years tested, 2008 came out on top while 2000 settled dead last. What was it about 2008 that made the 50 MA such a lucrative signal? What about 2000 made the strategy fail so miserably?

Consider the 2008 SPY chart below with the highlighted crossovers (click to enlarge).
[Source: MachTrader]

The notable performance in the trading strategy for 2008 is a direct result of the trending nature of the market in that time frame. Simply put, moving average trading systems shine in trending markets. If a stock experiences strong follow through after breaking above or below the 50 MA, this approach is a virtual ATM machine. Since the rules dictate one is always long or short the market, it allowed unfettered participation in the lion's share of 2008's sell-off.

Since the 50 MA is most effective in trending markets, reason would tell you it must be quite ineffective in non-trending markets. Might this be the trouble with its performance in 2000? Consider the following chart.
As you can see the first two thirds of 2000 were a veritable chop-fest rife with many a false signal. Though the last few months produced solid profits for a short trade, it wasn't closed until early 2001. Thus, the Achilles heel of this strategy is undoubtedly range-bound market.

Unfortunately it's difficult to consistently forecast whether the market will exhibit trending or range-bound behavior. Thus, the hope with the 50 MA strategy is that the draw downs incurred in the occasional choppy market are overcome by the profits captured once the market starts trending again. That hope certainly bore fruit over the last decade. Whether it remains as potent going forward remains to be seen.

Wednesday, July 28, 2010

The Effectiveness of the 50 MA

As mentioned yesterday, the 50 MA is a tool of choice for many chartists in determining their outlook on the overall market as well as individual securities. Equipped with a few simple rules and my semi-adequate Excel spreadsheet skills I set out to determine whether or not this moving average is worth its weight or just another indicator cluttering up my chart. Before delving into the results, let's first establish the gist of the trading plan.

1. Buy the SPY on a 1+% break above the 50 MA.
2. Sell short the SPY on a 1+% break below the 50 MA.

As outlined, the system dictates one always has a position (long or short) depending upon whether the SPY is above or below the 50 MA. For simplicity purposes I assumed one was simply long or short one share of the SPY. To reduce the risk of whipsaw, I required the SPY to break the 50 MA by at least 1% to generate a signal. Settling on a proper filter for a trading system is always a dilemma as there is an inherent trade-off. Though using a break of .5% instead of 1% would have generated quicker signals and thus better entry prices, it inevitably would have resulted in more false signals. No price filter will work every time, so it's really a matter of finding what works best the majority of the time.

The graphic below displays the outcome of the trading system from 2000 to 2010.

The table is broken down to the 50 MA's performance per year with both the best and worst years highlighted. Of the 71 buy/sell signals I found, 28 were winners and 43 were losers. At first blush, that doesn't look so effective, however, it's not just about number of wins versus number of losses. To gain a complete picture we must also take into consideration the average gains captured on the winning trades versus the average losses incurred on losing trades. Of the 28 winners, $7.61 was the average gain. Of the 43 losers, $2.12 was the average loss. Shown in this light, the trading system looks much more appealing.

Given that I did this by hand, I don't doubt I may have missed a signal here or there or have a few errors in the numbers. Be that as it may, I'm confident it wouldn't have changed the conclusions we can draw from this whole exercise. Tomorrow I'll compare the best and worst performing years to hammer out a few strengths and weaknesses of using moving average signals.

Tuesday, July 27, 2010

The Nifty Fifty

Of the myriad of technical indicators available, moving averages have risen as not only one of the most popular, but also one of the most effective. Perhaps their popularity is due in part to their simple yet versatile nature. Traders can use them for anything from identifying trends and reversals to measuring momentum and crossovers. Though moving averages can be measured on any time frame, the 50 day moving average has become a staple for most chartist. Indeed, it comes default on most charting platforms and is often used to aid in identifying the intermediate trend of the market.

I suspect many traders (myself included) took note last Thursday as the SPY mustered the strength to breach its declining 50 MA. Those subscribing to the notion that the 50 MA provides quality signals no doubt used this breach as a clarion call to dispense with their bearish aspirations for the time being and perhaps dip their toes in the water on the long side.

As with any strategy or method of analysis, the proof is in the pudding. If breaking the 50 MA has provided profitable signals in the past, then directional traders ignore this signal at their own peril. Thus far the SPY has seen four different occurrences of breaking the 50 MA in 2010 - all of which proved fruitful.
[Source: MachTrader]

Admittedly, four signals is too small a sampling size to draw any meaningful conclusions. Suppose we looked at the performance of the 50 MA signal going back to 2000. With ten years of data and 70 plus crosses to learn from, we certainly have enough data to pass judgement on whether this moving average is all hype or worth observing.

I'll divulge my findings tomorrow. Stay tuned...