Tuesday, January 26, 2010

Gaming the Selloff with Put Ratio Spreads

With the massive selling drying up a tad over the last two days and the SPX catching a bid, we've seen the VIX move predictably lower. So far so good for any one that chose to short volatility into the spike on Friday.

Speaking of fading the VIX- what types of strategies could a trader use when betting on a declining VIX?

If you were comfortable with the nuances of futures, you could certainly look to short VXX or enter bearish VIX option plays. For those reticent to try their hand at these more complex products, how about keeping it simple and playing with options on the SPY? There are quite a few short volatility strategies to choose from depending on your outlook.

In Adam Warner's recent post, Bernanke Ultimatum...And Some Skew, he mentioned a few observations from Ticonderoga Securities regarding the volatility skew that has arisen in various ETF options including the SPY. As mentioned in Volatility Skew and Ratio Spreads, vol skew occurs when further OTM put options trade at higher vol levels than ATM put options. To exploit the skew, Ticonderoga Securities suggested initiating a risk reversal by selling an OTM put option and simultaneously purchasing an OTM call option. While the risk reversal is a legit way to take advantage of the pumped up put options, what if a trader is unwilling to make a bullish bet? Any other short vol strategies that do well even if the SPY drops a bit further?

How about the good 'ole 1x2 put spread-

Take a look at the following SPY option chain paying close attention to the IV (implied vol) column. Notice how IV increases as the puts move further OTM. We could construct a 1 x 2 put spread by purchasing the Feb 104 put for $1.11 and selling two Feb 101 puts for $.67.

[Source: EduTrader]

The beauty of having a risk graph is you can play around with different strike prices and see the effect it will have on your risk-reward. I simply chose the Feb 104 and 101 puts as an example. If you wanted to receive more credit you could either tighten up the spread by decreasing the distance between the strikes (i.e. buy 104, sell 103) or by using higher strike puts.

The ideal scenario would be the SPY drift lower and reside around the short strikes (101) at expiration. The downside risk lies in the fact that you're shorting naked puts. While you want the underlying to move lower, if the decline in price gets too out of hand the losses can start to mount.

Monday, January 25, 2010

The VIX and Top Picking

In response to my previous post regarding the rapid rise in bearish price action, Siull asked how one might identify a top in the VIX.

Remember, the VIX is a statistic that tends to exhibit mean reversion over time. With few exceptions (2008) it's fairly easy to bet that sharp rallies in the VIX will be short lived. The other thing to keep in mind is that most traders use the VIX as a contrarian signal, an approach which probably gave rise to the popular phrase, "When the VIX is high, it's time to buy; when the VIX is low, it's time to go." In other words, VIX spikes tend to coincide with short term market bottoms. Though the phrase implies one could use the VIX for buy and sell signals, in my experience it's much easier to identify a peak in the VIX (buy signal) than a trough (sell signal).


When complacency becomes entrenched, it tends to stay awhile. Whereas fear and panic can come and go rather quickly.

Like any other methodology there isn't one fail proof technique that works in identifying a top in the VIX every time, however there are a few popular signals I've adopted from others that seem to work the majority of the time. One of the most obvious technical indicators that complements the VIX quite well is Bollinger Bands. Over the last 6 months, the VIX has probed above the Bollinger Bands four times (not including the current VIX spike). Each one signaled a short term bottom in the SPX and subsequent buying opportunity.
[Source: EduTrader]

What if this time is different? What if the uptrend in the SPX is toast and we're back to a bearish trend? If I'm all out bearish on the market and am not comfortable using VIX spikes to enter bullish trades, then bare minimum I would avoid entering new bearish plays when the VIX is overbought and may consider it as a signal to take profits on short term bearish plays.

In addition to Bollinger Bands I've also seen traders compare the current value of the VIX to a 10 day moving average or to recent realized volatility such as 10 or 21 day HV.

Thursday, January 21, 2010

Changing of the Guard

Quite an interesting little turn of events we have going on the last few days. We haven't seen a sell off of yesterday's magnitude since October. Nothing like a 2% drop to wake the market from its slumber. Tack on a 30+% rally in the VIX and we may just have sufficient reason to start considering being more active with bearish bets. After last July's debacle, I've been a bit reticent to aggressively enter any bearish plays. So far that's been a smart position to take, but based on recent price action my inner bear is starting to get antsy. As mentioned in my Buy the Dips Sell the Rips post, when bearish I prefer using rallies as an opportunity to reload on bearish positions such as selling call spreads.

A quick glance at a 30 minute chart of the SPX shows we now have a decent amount of overhead resistance in the 1130-1150 area.
[Source: EduTrader]

Those currently in the bear camp may consider rallies into this area a potential shorting opportunity. If we break back above 1150 to new highs in the SPX, then all bets are off and I'll have to set aside my bearish aspirations for the time being.

In the short term this sell-off is overdone and likely to bounce in the near future. Based on the sharp rise in the VIX over its upper bollinger band, the build up in fear has gotten too excessive and will likely subside.

Wednesday, January 20, 2010

VIX Options Laid to Rest While the Cash Springs to Life

With this morning's settlement coming in for January VIX futures and options, we now know which expiration play mentioned in last weeks Expiration Musings had the upper hand. Due probably in part to the IBM beat down after hours last night following its earnings announcement, the major indices all gapped down this morning. The VIX in turn jumped up roughly 5% out the gate opening the day at 18.51. Settlement came in a smidge higher at 18.87.

Though both trades mentioned came out winners, the long 21 Jan put purchased for $1.10 produced the larger gain ($1.13). The profit would have actually been much better were it not for today's gap. The January cycle was yet another example where the premium in VIX futures proved unwarranted and was therefore snuffed out as the futures inevitably dropped to the cash.

I also noticed with today's notable sell-off, 10 day historical volatility on the SPX rose to around 14.5%, a level not seen since the beginning of December.

[Source: EduTrader]

If realized volatility of the SPX starts to find a home in the 14-15% range, my bet is the VIX will be reticent to probe much lower than its current 52 week low of 17. Though I don't want to make a mountain out of a molehill by reading too much into today's sell off, if today's price action is a sign of things to come the VIX won't be near as heavy in the coming weeks as it has been over the past month.

For related posts, readers can check out:

Sunday, January 17, 2010

The Replacements- As Good As The Original?

Say you've accumulated a notable unrealized gain in a long IBM stock position. With Tuesday's earnings announcement quickly approaching you may be wondering how to manage your position. Though Big Blue doesn't have a history of huge earnings moves, there's always the remote chance of something crazy happening.

How about selling half your position? Or selling a covered call to partially hedge your position, or perhaps opting for the more complete protection of a collar? Though all are legitimate considerations with varying trade-offs, Friday night's Options Action suggested a Stock Replacement Strategy. The gist of a stock replacement strategy is to maintain one's exposure to further upside appreciation in a stock, but do so using derivatives, which may offer a more leveraged, cost-effective, or less risky approach.

The specific suggestion mentioned was to sell your IBM stock position and buy an April vertical 130-140 call spread for $4.00. One of the most obvious advantages to this strategy is the drastic reduction in risk. A long stock position (100 shares) of IBM currently has $13,200 of theoretical risk. The 130-140 call spread has a mere $400 at risk. The call spread also enables you to participate (to an extent) on any further appreciate in IBM stock. Since you entered a 10 spread for $4, your max reward is capped at $6. This limited profit represents the main drawback to this strategy. If a trader decided to take the stock replacement route they would have to be comfortable with capping any further gains to $600. Consider the risk graphs illustrating both positions:

[Source: EduTrader]

So is the stock replacement strategy an adjustment worth considering? You be the judge. As for me, I'm always open to plays that drastically reduce risk while still holding the door open to more profits.

Wednesday, January 13, 2010

Expiration Musings

Apologies for the sparse posting since the new year rolled in. I've been swamped with other business and have found it difficult to find adequate time for my blogging. A few months ago I wouldn't have thought twice about only posting a few times a week instead of every trading day. Now I seem to feel a bit guilty anytime the blog gets neglected for a day or two.

If you're just tuning into the options arena, we've got expiration for January options rapidly approaching. Tomorrow marks the final trading day for index options such as the SPX and RUT, while Friday marks the final trading day for equity options. So if you've got any short Jan option positions remaining on your books, make sure to take care of those so as to avoid any unwanted assignment issues. Looking ahead to next week we've got VIX January options expiration on Wednesday. As is customary, let's take a look and see if we can find any short term expiration plays on the VIX. First off, let's recap current prices-

SPX 10 day HV = 12
VIX cash = 17.85
Jan VIX Futures = 19.50

Despite only having about 4 trading days before expiration, VIX futures are still trading at almost a 2 pt. premium to cash. As mentioned previously both will converge by expiration so that 2 pt. premium will diminish by next Wed - either cash rising to future or future falling to cash (or both). If memory serves correctly, VIX futures have had it wrong for quite a few months as the anticipated rise in the cash has yet to materialize. But hey who knows- maybe the blind squirrel futures traders are about to find their proverbial nut.
[Source: EduTrader]

From a bullish perspective one could make the case that the VIX probe below the bollinger bands on Monday may be signaling it's high time for the VIX to rally. Though I'd say that argument is on shaky ground given today's snap back rally in the SPX and subsequent resumption in VIX decline. If I were to consider a bullish play I'd probably look to sell January naked puts. The 19 strike put, currently trading at $.55, is really the only one worth considering. Here's the risk graph:
From a bearish perspective, one could certainly use Wednesday's sharp snap back rally as a sign that the resilient bulls are still coming out in force each time the market experiences any type of shallow pull back. If you think the market rally continues, it stands to reason the VIX will remain heavy into Jan expiration and a put purchase may just be your best bet. Instead of simply purchasing the 19 strike put, I'd opt for buying something ITM to raise your break even point. Let's use the Jan 21 put, currently trading around $1.10, as an example:

Monday, January 11, 2010

Options Action- JPM Risk Reversal

The subjects covered in my last post, namely sector rotation and imploding volatility, received some face time in Friday night's Options Action. What insight did the gurus have to add?

Well, none really.

As to whether or not the rotation out of tech and into financials is here to stay, the best two points made were:
1. it's tough to read too much into one week's worth of trading (agreed) 2. if the market's uptrend continues, no doubt technology will be bought up and one point or another so the weakness may be short lived (agreed).

What about volatility? All fingers pointed to the usual suspects most of us are no doubt already aware of: low volume over the holidays, less trading days in the Jan cycle, and an absence of any huge market moving events.

As earnings season is coming round the corner, a few earnings related option plays were discussed. The one I'd like to muse over for today was a risk-reversal on JP Morgan Chase (JPM) currently trading around $44.60. In anticipation of a neutral to mildly bullish earnings reaction, the suggestion was to simultaneously sell a Feb 42 put for $.85 and buy a Feb 48 call for $.50 resulting in a net credit of $.35. For those that are in unfamiliar territory when it comes to risk reversals, it can be easily understood when broken down into its individual parts. It simply involves selling one OTM put and then buying one or more OTM calls with the proceeds.

By selling the JPM Feb 42 put, you obligate yourself to buy 100 shares of JPM at $42. The ideal scenario would be for JPM to remain above 42, allowing the put to expire worthless and you to keep the $85 credit received. By also purchasing the Feb 48 call for $50 debit, you gain the right to purchase JPM if it rises above $48 by Feb expiration. The alluring aspect of adding the 48 call to the short 42 put is that you now have unlimited upside profit potential if JPM rallies strong off of earnings. The drawback to the long 48 call is that you have to give up $50 of the $85 credit received from the short 42 put. If JPM fails to rise sufficiently, then you've essentially thrown away that $50.

Normally I'd offer up a risk graph illustrating the pay-off diagram for the trade, but my software is refusing to give me option quotes. So the following chart will have to suffice for now. I'll post the other chart when my platform decides to get its act together.
[Source: EduTrader]

I tend to prefer simply selling puts to entering risk-reversals, especially since buying short term OTM options is usually a low probability bet. Though if I wanted to swing for the fence and bet on a large bullish move, risk-reversals aren't a bad way to do it.

For related posts, check out:

Thursday, January 7, 2010

Jobs on Deck

So looks like all eyes are on the jobs report set to be released tomorrow morning at 8:30 AM EST. Perhaps it will be just the catalyst we need to jump start this market and save realized volatility from tumbling into the single digits again. Which measure of volatility you ask? That would be none other than 10 day HV of the SPY, my gauge of choice when assessing short term market movements.

Though SPY volatility continues to implode we have seen some signs of life in a few select sectors of the market. Those of you who monitor the various sectors of the market have no doubt notice the breakouts taking place in both financials and energy. Over the last week both have performed like champs scoring 4% and 6% moves respectively. Not too shabby considering the SPY is up a mere 1% (click image to enlarge).

[Source: Yahoo! Finance]

On the bearish front, tech seems to have run out of gas over the last few days. Seems like we could make the case of some sector rotation taking place. Whether it's a short term aberration or a new theme only time will tell.

For related posts, check out:

Tuesday, January 5, 2010

Mail Time- Naked Puts vs. Put Spreads

I received the following question a few days back via e-mail.

When would you sell naked puts vs. put spreads?

I tackled a similar question back in an April Mail Time post, so I'm going to draw today's response largely from there. The first consideration is the price of the underlying. I typically only sell naked puts on stocks around $40 or below. If it's a higher priced stock I'll simply sell a put spread to limit risk and margin required. For example, I would never ever sell a naked put on the RUT or SPX as it would tie up way too much capital and involve an exorbitant amount of risk. The one exception to my usual price parameters has been the occasional times I've sold puts on GLD. Most recently I was short the Jan 102 and 103 puts. My primary rationale for not selling spreads even though it was a $100+ stock was I didn't need the additional capital that was tied up in margin and I was a willing buyer of gold around the 100 level.
[Source: EduTrader]

The other consideration may be a traders outlook on implied volatility. While selling puts outright is more of a pure short volatility play, selling put spreads is a hedged volatility play (since you're both long and short options). So your position vega will obviously be higher with the naked put compared to the put spread.
[Source: EduTrader]

For related posts, readers are encouraged to view:

Sunday, January 3, 2010

Best and Worst Trades of 2009 Part II

While my first "Best and Worst Trades of 2009" post brought me back to some of the darker days of this year, today's post allows me the opportunity to focus on a few of my better trades of 09. Though I've made plenty of decisions that afterwards often cause me to question my sanity, I have been fortunate enough to get a few things right. While June was probably my best month from a P/L standpoint, I'd say December was my best month based on my market forecast and execution. I seemed to have had the Midas touch there for awhile. My success in December was probably due to the fact that a variety of factors combined to make last month a veritable boon for volatility sellers (which defines myself more times than not). What factors were those exactly? My top two would be seasonality and volume. Over the Christmas stretch we have more holidays usually resulting in a dip in implied volatility as options seek to price in less trading days than normal. Volume also dies down to pathetic levels increasing the odds the market remains in snooze mode. So as with any instance where options are ostensibly overpriced, I pick a few choice securities and start selling volatility. If I have a directional bias, I'll opt to sell either puts or calls (or spreads); if I don't have a directional bias, I may opt to sell both. Following is a list of some of my best positions last month.

USO Jan 37 puts
GLD Jan 102 puts
RUT Jan 550-540 put spread
SPY 117-122, 102-97 Jan Iron Condor

I've taken profits on all but the call spreads on the SPY.

Today's post wraps up my 2009 year end review. Let's all have a profitable 2010!