Monday, May 31, 2010

Evolution of a Bullish Risk Rocket

Since highlighting gold's breakout in April's Time to Shine post, we've seen the precious metal surge up to $1250 and subsequently fall back to its breakout point. Those familiar with technical analysis 101 know that prior resistance often becomes new support. The price action of GLD over the last month serves as one such example of this basic tenet (click any image to enlarge).
[Source: MachTrader]

To take advantage of last week's textbook bullish retracement pattern, suppose we entered a bullish risk rocket on May 21st by purchasing 100 shares at $115.90 and two June 121 calls for $1.55 apiece.
As mentioned in previous risk rocket discussions, the initial target for the stock is a mere 1 ATR. With last Wednesday's gap we would have been able to sell the stock around $118.50 for a $260 profit. This gain reduces the risk on the two call options from $310 to $50. Traders still aggressively bullish on GLD may opt to simply hold onto the long calls and find comfort in the fact that their remaining risk is a small $50. Those with a less aggressive outlook wanting to further diminish the risk involved may consider rolling the calls into some type of spread. As illustrated in the Decision Tree post, potential choices may include bull call spreads, ratio back spreads, butterflies and condors. For GLD I elected to roll into a bull call spread by selling 2 Jun 124 calls for $.91 apiece.
Due to the $182 credit received from the short calls, our remaining risk is eliminated and we now stand to gain $132 minimum reward. Best case scenario occurs if GLD resides above $124 at June expiration. By expiring in-the-money, our call spread will realize it's full profit potential. Within the decision tree displayed below we are currently in T2. Depending upon how GLD performs over the next few weeks, we may think about making one last adjustment into a butterfly or condor by adding a bear call spread. It really comes down to whether there is sufficient premium in the out-of-the money calls to make it worth our while.
For related posts, readers can check out:
Adjustment Thinking and the Salvation Syndrome
The Sling Shot
Risk Rocket

Tuesday, May 25, 2010


I'm in California so my posting will be sparse, if not non-existent for the remainder of the week. I should be back to my normal blogging self next Monday.

Thursday, May 20, 2010

Public Enemy #1

In Tuesday's ratios post, I mentioned the struggle between Gamma and Theta that builds into expiration. The events of the past few days illustrate well the perils of holding short gamma positions too long. This is an instance where the extra rope lent to the ratio spread definitely turned into a noose. It also shows why Gamma is an option sellers most treacherous foe.

But hey such is life for a trader selling short term options. Look, you want quick rates of time decay, fine. But for as many times as you get to enjoy the additional and oft times quick profits you rake in from riding to expiration, you're going to have to inevitably deal with the occasional horror show where the market makes a kamikaze run for your short options. In the long run, the extra few bucks accumulated from riding to expiration unscathed typically pale in comparison to what's forked out to pay the piper when those short options come back to bite ya.

It's the tale of two expiration's. Sometimes options go out like a lamb, sometimes they go out like a lion.

So how do option sellers protect themselves from public enemy #1? It's simple really. They steer clear of short term options. This is why you find traders who sell two or three month iron condors or strangles as opposed to front month. They've opted to forego the alluring high rate of time decay offered by short term options for the lower gamma risk of longer term options. In addition they may avoid holding short options too close to expiration by closing them one or two weeks prior.

For related posts readers can check out:
Gamma Facts

Wednesday, May 19, 2010

Time to Catch a Falling Knife?

Careful with the song... it's addicting.

And for those of you LOST fans out there, here's the more ominous, eerie rendition from this season's "Sundown" episode.

So you want an example of a falling knife? How about oil over the past month... yowza. It's sliced through multiple support levels like butter. Nothing like a 20% drop to smack the complacency out of the bulls. At it's current position simply saying it's oversold is like saying Michael Moore is chubby. An understatement to say the least... It's overstretched based on virtually any measurement- stochastic, RSI, bollinger bands, et. al. But, might today's price action finally be pointing towards some exhaustion? In addition to the extremely oversold nature, we've also got high volume bordering on climactic and a strong bullish reversal candle. Admittedly, trying to catch a falling knife is not for the faint of heart and can be very difficult. Were I to stick my neck out and try it, here's a few things I'd consider...

Due to the severity of the sell-off, implied vol is not surprisingly through the roof. In addition, the volatility skew of downside puts is quite pronounced making them a tempting short. The beauty of shorting OTM puts or put spreads versus buying stock when betting on a bounce is the fact that you have a bit of a buffer before reaching your expiration break even. You're also positioning yourself to profit from a drop in implied volatility which will likely occur if the stock pops. Consider the risk graph of a July 30-27 put spread:

[Source: MachTrader]

Since there's always the off chance that this oil sell-off turns into a 2008 rip the head off the bulls style free-fall, I would be very judicious in my position sizing. Keep in mind one of the easiest ways to manage risk is by keeping positions small.

Addendum: I penned this post yesterday, so today's gap down pretty much negates the potential signs of a bottom in yesterday's price action. I'd wait for the smoke to clear and reassess before doing anything with USO.

For related posts, readers can check out:
Naked Puts vs. Put Spreads
Rolling with Crude Oil

May VIX Settlement

Though I've periodically assessed potential expiration plays on the VIX, I haven't really given it much attention over the last two expiration cycles. Perhaps I'll drum up some content for June's cycle.... For anyone who played with May VIX options, today's open ushered in the settlement calculation. With the minor gap down in the S&P, we got a little pop in the VIX right at the open to 34.65 or 3% higher than yesterday's close. This go around settlement was right inline with the open.

[Source: CBOE]
As with the other indices, the settlement value of the VIX can also be charted using a specific ticker symbol: VRO.

Tuesday, May 18, 2010

Ratios, Ratios, and more Ratios

Ratio spreads turned out to be the talk of the table during last week's Option's Action. Though cynics may sight their occasional misleading statements (as I've done before), they do a pretty good job of summing up various option strategies. This go around was no exception as their ratio spread summary was on point. They even touched on the potential drawbacks of shorting extra naked puts and encouraged traders to exercise caution when doing so.

Speaking of ratios, the SPY ratio spread mentioned in April's Volatility Spike and Ratio Spreads is coming right into make it or break it territory. The ideal profit zone for the May 1x3 117-113 put spread sits right around the $113 level making the obvious best case scenario a pin right at $113 going into expiration this Friday. Unfortunately with the type of volatility we're seeing play out day to day, this desirable outcome is far from a slam dunk. We've entered the final phase for May options where the two greek titans, Gamma and Theta, will commence duking it out. While our ally Theta's momentum has been building and he possesses the ability to deliver some serious profits over the next three days, Gamma isn't afraid to fight dirty. Don't forget his momentum has been surging as well, especially now that our short options are sitting at-the-money.

[Source: MachTrader]

While I'd like to say I'm fully vested in this play and ready to see it through to the end, truth is I bailed after the flash crash and subsequent snap back rally. Call me crazy, but that crash gave me the heebie jeebies and I considered myself lucky to get back close to even. Were I still in, I may attempt to hold out for a few more days to give Theta some rope. But if the market sell-off turns nasty I'll be quick on the exit trigger lest Gamma turn that rope into a noose.

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

Monday, May 17, 2010

AAPL Options... A Steal or Too Rich?

Received a solid volatility question last week from Kevin. Let's take a stab at it:

My question is regarding and understanding the chart and the figures in the table above the chart. If you look at AAPL, the implied volatility is around 36% and the historical vol is 39%. If you look at the 52 week high on historical vol in the table it shows on May 12th the high was 58.65%, but nowhere on the chart does this show up. One more question in looking at AAPL IV- if we take the range it's traded in, it looks to be just above the half way point so I would take that as IV being in the high category. Is this correct?

Thanks for the question Kevin. When speaking of historical volatility, keep in mind there is not one historical volatility reading. HV can be measured over any time frame. The table within ivolatility displays three different HV lengths: 10 day, 20 day, 30 day. The chart below the table only shows 30 day HV. The 52 week high of 58.65% that you mentioned in your question was that of 10 day HV, not 30 day. The 52 week high for 30 day HV is 39.7% which you'll notice is shown in the chart. I've done a couple previous write-ups discussing the nuances of historical volatility which will help shed insight on this part of your question. You can view them here: Part I, II, III, IV. Click image below to enlarge:

[Source: Ivolatility]

On to the second part of your question regarding whether AAPL IV is high or not. There's generally two ways of assessing volatility. One is comparing IV to its historical range (as you have done). In that respect, yeah AAPL IV is toward the upper end of its one year range and thus high relative to its historical norm. The second method you could use is comparing implied vol to historical vol. Currently IV = 41%, 30 HV = 40%, 20 HV = 48%, 10 HV = 56%. When compared to HV, rather than looking expensive, IV actually looks in-line to cheap. At the end of the day the only volatility that really matters is that realized by AAPL throughout the duration of your trade. If you were to buy vol via a straddle at 37% IV and AAPL continued to realize 48% volatility (current 20 HV), options are actually cheap. The only way AAPL options are expensive right now will be if AAPL settles down and HV drops. If AAPL continues to realize the type of volatility we've seen over the past 10, 20, and 30 days, AAPL options are in-line to cheap.

For related posts, readers can check out:
Implied Vol vs. Historical Vol
Relativity of Volatility
Finding Volatility

Friday, May 14, 2010

Blast Off...

After three valiant attempts to break above the 50 day moving average on the S&P 500 Index, the balance of control seems to have shifted back to the bears for the time being. With today's downdraft, I was able to initiate the first adjustment on the SPY risk rocket by covering the short 100 shares around $113.50. Given that we initially shorted shares at $116.50 and purchased two Jun 111 puts for $1.95 apiece, this 1 ATR gain of $3.00 drops the total cost basis of the puts from $3.90 to $.90. At this point, I could opt to simply hang on to the puts and take comfort in the fact that I've dropped the risk to a mere $90. Or, I could initiate one of the secondary adjustments outlined within the decision tree in my previous Risk Rocket post.

After playing around with various adjustment, I chose to roll into an OTM put butterfly. In addition to the long two Jun 111 puts, I shorted four Jun 106 puts and purchased three Jun 101 puts. The one variation I added was the extra 101 put. This opens up the downside of the risk graph to allow better participation if the market falls apart again (click image to enlarge).

[Source: MachTrader]

Tuesday, May 11, 2010

Risk Rocket

In last month's Sling Shot post I reviewed a bullish combo strategy involving the simultaneous purchase of stock and call options. The power of the play lies in its ability to be adjusted into various risk free spread positions. Given the multiple adjustments available I suggested using decision trees to better organize the varying choices at different forks in the road. Turns out the phrase "sling shot" has been used to describe another option strategy. I've never been one to quibble over names of strategies as I believe the key lies in understanding the structure of the play and how to manage it, not the name. However, for simplicity purposes it's obviously nice to have some type of name for each strategy. I mean, long stock long call combo doesn't exactly roll off the tongue, ya know? So, given its similarities to a risk reversal, going forward I'll refer to this particular play as a Risk Rocket.

With this week's historic turn of events and the potential trend reversal playing out in the overall market, let's explore a bearish risk rocket poised to exploit a continued downward move in the SPY. Suppose we shorted 100 shares of the SPY today around $116.50 and simultaneously purchased two June 111 puts for $1.95 apiece. Take a gander at the risk graph:

[Source: MachTrader]

The game plan is to buy to cover the stock within a few days, following a 1 ATR drop. The profit from the stock should pay for most of the cost of the long puts. Following this initial adjustment we may consider rolling the long puts to some type of spread in order to bring in additional credit. The premium received will further reduce the risk of the position and potentially put us into a minimum reward scenario. The following decision tree outlines potential adjustments for consideration:

Assuming this play pans out, I'll offer a follow up post exploring various adjustments.

Monday, May 10, 2010

Gamma Scalping Inquiry

I received the following question regarding last week's RIMM and Gamma Scalping post.

Great post Tyler! Gamma scalping is one of those subjects that gives me a glimpse into the mind of a "real" trader. You are a much better directional trader than I am, so I am wondering: is this a strategy you do regularly? How much of your account would you put into a scalping straddle? Do you re-adjust the position when it moves a certain percentage or delta, or do you rely on support/resistance on shorter time frame charts?


Thanks for the question Jon. Perhaps you give me too much credit on being "a much better directional trader" than you. Nonetheless I appreciate the kind words. Gamma scalping is not really a strategy I do that often. Though in theory it seems like a slam dunk, when the rubber meets the road there's a lot of moving parts that have to come together to make it work well. Since much of 2009 and 2010 has experienced a declining volatility environment, I haven't seen much of an edge in being a net buyer of options. The occasional corrections have obviously reward option buyers, but those have been few and far between. Remember, the ideal market environment for straddles (and gamma scalping) is one in which the realized volatility of the underlying is significantly higher than the implied vol paid for in the option's at trade inception. The reason I gave the straddle a shot on RIMM was because its volatility seemed at a cyclical low making option's a more tempting purchase.

As far as position sizing goes it really comes down to personal preference. I'm not sure I'd treat a long straddle much different than any other individual options play regardless of if I'm gamma scalping or not. So if you typically risk 2% of your account in each individual trade, I'd keep it similar with the straddle. Though you're not taking on a lot of directional risk when entering a straddle, you are fighting time decay the entire time which can start to add up if the underlying doesn't move sufficiently.

Timing has always been the toughest part of gamma scalping for me. You're never going to find a technique that works every time, so it's really about finding whatever is the most consistent in the long run. Let's review a few popular methods:

1. Technical Analysis: If you're fairly adept at identifying reversal points in a stock's price, you could certainly use charting to better identifying when a stock is poised to reverse course. This would be a logical time to gamma scalp to lock in any accumulated gains.

2. Fixed Intervals: If you shun the subjectivity of chart reading and prefer instead to take a more objective route you could opt to re-hedge at fixed intervals such as every time the stock rises or falls by one or two ATR's. Or perhaps adjust when your position delta changes a certain amount.

Thus far I've probably used a blend of both.

For related posts, check out:
Gamma Facts
Clash of the Greeks
Clash of the Greeks Part Deux

Wednesday, May 5, 2010

RIMM and Gamma Scalping

In last month's post titled RIMM Options on Sale? we made the case for a potential low in implied volatility for the crack berry maker. Though I'd like to attribute the call to my cunning intellect, there may have been a dash of luck involved. The recent tone of the market has certainly helped as its been a rising volatility tide lifting all boats. The original RIMM analysis relied on the cycle of implied volatility as well as HV-IV analysis, two methods of volatility forecast. For those interested in learning more of volatility charts, I suggest reviewing the original commentary regarding RIMM's setup. The following chart displays the timing of the initial post and subsequent volatility rise.

[Source: Livevol Pro]

In an attempt to exploit the expected rise in volatility, suppose on April 14th with RIMM trading at $73 you decided to enter a May 70-75 strangle for $3.50. Though you virtually nailed the bottom in volatility, had you simply sat on the trade and done nothing since inception you would have very little gain to speak of. Though volatility has experienced a nice ramp up, you've been fighting time decay the entire time and have failed to see much of an extended move in one direction or the other in RIMM's stock price. But alas, such is the nature of a long strangle. Though straddles and strangles are touted as bi-directional trades, truth is you really need a large move in one direction to start raking in the dough. Any type of back and forth churn (like RIMM over the past few weeks) can cause losses due to time decay start to mount.

But is there a silver lining to back and forth churn? Might there be some way to take advantage of these back and forth swings? The answer lies with gamma scalping. The nature of a positive gamma trade, such as straddles/strangles, is to get you longer into rallies and shorter into dips. It is possible to use stock to lock in short term unrealized gains on a strangle trade. This can be accomplished by shorting stock into rallies and buying stock into dips. From a delta perspective, we're using stock to re-neutralize our option's position. From a risk graph perspective, we're using stock to re-center the graph. Consider the 70 straddle risk graph displayed below (click image to enlarge):

[Source: MachTrader]

Suppose after entering the trade RIMM proceeded to rally from $70 to $73, drop back to $70, drop to $66, and finally rally back to $70. Though we're seeing a decent amount of volatility, by reverting back to $70, the straddle keeps giving back its gains. Had we taken the gamma scalping route by shorting shares of stock near $73, and buying stock towards $70 or $66 the outcome could have been drastically different.
Gamma scalping successfully requires actively monitoring your position and dealing with the perpetual dilemma of timing your adjustments which is often times easier said than done. It can serve as a powerful weapon in combating the back and forth churn that often frustrates straddle buyers.

Tuesday, May 4, 2010

Goldman Sacked

Thus far I've avoided sticking my neck out and jumping into any GS positions. With the drama unfolding day to day and news driven movement it's been tough to make heads or tails of Goldman's price action. Fortunately, options offer the versatility of making hedged bets with a wider profit zone than buying or shorting stock outright. Friday night's Option's Action threw out an interesting trade idea to exploit a potential bounce back in Goldman's stock price as well as take advantage of elevated option premiums. Let's breakdown the suggested ratio spread.

Buy 1 Jun 155 call for $5.60 and sell 2 Jun 165 calls for $2.80 apiece. Since the credit received from the short calls is sufficient to pay for the long call, the trade is entered at zero cost. Now, keep in mind zero cost does not mean zero risk. Due to the extra short call, the upside risk can become substantial and your broker will hold aside margin. Consider the risk graph:

[Source: MachTrader]

First off, notice how a decrease in volatility shifts the risk graph upward thereby increasing one's profit. The sweet spot of the profit zone at expiration is between $155 and $175. The most advantageous aspect of the trade structure lies in the absence of downside risk. Thus if GS continues its bearish ways you need not worry about mounting losses. The upside risk could become a problem, but I would be surprised if GS reclaims $175 over the next month. Though this trade structure succeeds in exploiting some type of minor bounce, I'm not sure it's the best play if my objective were to exploit the elevated volatility. Currently downside puts are trading at higher vol levels than upside calls, so traders may consider experimenting with some type of OTM put ratio spread such as the one highlighted in Volatility Spike and Ratio Spreads.

For related posts, reader's can check out:
Gaming the Selloff with Put Ratio Spreads
Gaming the Gold Bugs

Sunday, May 2, 2010

State of the Market

Though I devote the lions share of attention on my blog to option concepts, I have occasionally diverged from the beaten path to point out notable developments within the technical analysis realm. Since I was brought up with a fair amount of chart reading, I can't help but notice when identifiable patterns crop up in the price action of the overall market. Though I've toyed with the idea of blogging more about charting and my directional forecasts, thus far I've opted to stay focused primarily on option content. Perhaps one day I'll offer up a broader range of fodder for both option traders and chart junkies. As it stands there are no doubt countless other sites offering more chart analysis than you can shake a stick at. Today's post will mark yet another deviation from my norm as I highlight some significant patterns using the S&P 500 Index. First, a look at the weekly (click image to enlarge):

[Source: MachTrader]

Here are my three bearish observations. First, a close encounter with the 61.8% retracement of the entire 2007-2009 bear market. It seems the bulls initial attempt to breach this level has been rebuffed by the bears. Second, with eleven straight up weeks the market has definitely achieved overbought status. Third, last week's bearish engulfing candle deserves some consideration. Now, a look at the hourly:

The hourly has developed a rather pronounced head and shoulders pattern over the last week with 1180 acting as the neckline. I'll be interested to see how we react around this level in the coming days. It's also important to know when a chart pattern has failed. As I see it, a break back above 1210 (right shoulder) and especially above 1220 (head) would bring to pass yet another fake out and sucker punch to the bears.

Given that this two year meteoric rise in the SPX has been rife with many a false top and bear trap, who really knows whether this will turn out to be some type of major top. As for me I'll be taking it one day at a time. For now, I see 1180 and 1150 as two significant downside support levels to keep an eye on.