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...

Monday, July 26, 2010

The Rare Earnings Win-Win

Every once in a blue moon an earnings reaction comes along which provides a favorable outcome to both volatility buyers and sellers alike. It's not often that both types of players come out unscathed. Typically one of these camps is enriched while the other gets shafted.

Not the case with AMZN this go around. The online retailer seemingly provided goodies to all earnings players this season. Provided of course they had the right timing on their exits. Those buying vol pre-earnings via straddles and strangles would have been well served by adopting the ole' knee jerk take the money and run approach following the monster gap down. With a 10+% gap and the pre-earnings 120 ATM put option gaining $15 intrinsic value, you can bet straddles increased in value from Thursday to Friday. Given the immediate buying surge off the open, straddle owners would have been better off with a swift exit (click image to enlarge).

[Source: MachTrader]

Those selling vol pre-earnings via anything from iron condors to short strangles would have been well served by exercising some patience and allowing the gap fill to assuage their initial financial pain. As the day progressed the gap fill would have not only alleviated some of the accumulated morning losses, but likely turned them into profits. Let this serve as an example supporting patient reactions over perfunctory.

If you're inclined to play earnings and aren't already watching the intraday price action following the announcement, I would highly recommend it. Using a 5 minute chart to gauge whether the gap is initially bought up or sold into can aid in assessing whether to hold your position a bit longer or simply jump ship.

For related posts, readers can check out:
Earnings Season Primer
INTC...The Aftermath
Lessons Learned from a Trip to the Woodshed

Thursday, July 22, 2010

Vol Sellers Delight

Now that the dust has settled on AAPL earnings, let's take a look at how things have shaken out. Though market participants have a variety of expectations going into earnings, volatility traders fall into one of two camps. Those positioning themselves for a larger move than what the option board is pricing in and those looking for a smaller move. Call it the tale of two vol traders. Those long vol would love to see AAPL either pop or drop huge following the announcement. Those short vol prefer to see the announcement turn into a non-event lacking any type of fireworks.
[Source: Livevol Pro]

The latter scenario turned out to be the case this go around as AAPL's up gap got sold into with a vengeance. Matter of fact, by the end of the day AAPL had closed less than 1% higher than its pre-earnings close. Couple the tiny move with the 10 pt. drop in implied volatility and you've got an environment quite favorable to vol sellers. So it comes as no surprise that the iron condor mentioned in The Big AAPL came out a winner. I'd venture to say virtually any short vol play would have worked.

Here's an updated look at the condor's risk graph showing just under half of the profits already accumulated.
[Source: MachTrader]

Wednesday, July 21, 2010

VIX Expiration and Term Structure

July VIX options and futures expired this morning with a settlement price of $23.79. For any newcomers to the volatility scene, here's a quick review of two sources you can use to find the settlement price. First, the Chicago Board Options Exchange (CBOE) publishes the data within an hour or two after the open of expiration day within their Index Settlement Values page. Second, most charting platforms allow you the ability to chart the settlement price using the symbol $VRO.

[Source: CBOE]

In last week's A Volatility Inflection Point? post, we highlighted a short July 24 put play (for $.65 credit) to game an expected bounce in the oversold VIX. While the Volatility Index ended up settling just below 24, the position still produced a profit. Over the last few days, traders had numerous opportunities to cover the short puts anywhere from $.05 to $.10. This expiry cycle illustrates well the treachery of holding short options all the way to the end in an attempt to eke out every last penny.

Even though it looked as if a settlement above $24 for the VIX was all but guaranteed on Monday, Tuesday's kamikaze run for the short puts pulled the rug right out from under that viewpoint. Furthermore, quirky things have been known to happen around VIX expiration, making holding short, close to the money options into expiration all the more foolish. Though the settlement price came out to $23.79, who's to say it couldn't have been $23? A solid, profitable trade could very well have turned into a loser.

Here's an updated look at the current VIX term structure. The setup isn't really much different from last month as highlighted in the June VIX Settlement and Term Structure post. The futures remain in contango, albeit a bit steeper this go around and at higher levels than last month (click image to enlarge).

For related posts, readers can check out:
Settlin' Them VIX Options
VIX Options
Lessons Learned from a VIX Put Matrix

Tuesday, July 20, 2010

The Big AAPL

Going into earnings this evening, AAPL options are exhibiting the typical IV-HV difference where implied vol is notably higher than historical vol. Using our crafty vol charts provided courtesy of Livevol Pro, you'll notice the IV-HV differential is virtually in-line with where it was in past earnings announcements. So, nothing out of the ordinary to report here.

From a charting standpoint, AAPL has found a home in the 240 - 270 range over the past four months. Traders believing the tech powerhouse is likely to remain in this channel and desiring to play the post earnings volatility crush may consider selling an Aug iron condor. How about selling a 280-290 call spread and a 220-210 put spread for $240 credit? Consider the risk graph displayed below:
[Source: MachTrader]

Over at the Livevol Blog, they highlighted some worthwhile data points regarding AAPL earnings, including the fact that it's paid off to have a general bullish bias into earnings. Interestingly enough, selling straddles one strike OTM right before earnings, then closing them the day after has proved quite effective in exploiting the typical bullish move coupled with the volatility crush.

For related posts, readers can check out:
Earnings... the Wrench in the Theta Clock
Strangles versus Iron Condors
Saved by the Wings

Disclosure: Livevol Pro is an advertiser on Tyler's Trading

Earnings-Palooza!

This week ushers in yet another bevy of earnings from some of the heavier hitters. Last night IBM's report was met with little fanfare and saw its stock price down about 5%. This morning's GS announcement resulted in a sell-off, albeit much less than IBM. Tonight we've got AAPL reporting. Wednesday brings QCOM and MS. And finally Thursday includes reports from MSFT and AMZN. Suffice it to say, those playing earnings have a few seasonal favorites to choose from this week. If time permits I'll take a look at AAPL before the close today.

Thus far in this earnings cycle we've seen some classic buy the rumor sell the news action. Alcoa was up a solid 10 - 15% into the announcement before seeing its earnings gap sold into aggressively. Ditto for Intel. On top of the good earnings reactions getting sold into we've had a couple company's getting notably whacked such as Bank of America and Google. Though GOOG was pricing in about a $20 up or down move, it ended Friday down around $30.

Need some help passing the time till AAPL reports tonight? This from Kobe's biggest fan-

Monday, July 19, 2010

Expiring Monthly Guest Article

I had the opportunity to pen a guest article for Expiring Monthly's July edition (due out today) regarding adjustment trading. After giving my thoughts on directional versus non-directional traders I expand on the whole adjustment trading philosophy using example trades on Netflix (NFLX). Though I've written quite a few articles in the past, I thoroughly enjoyed putting this one together and believe it's a pretty good read. The title (not surprisingly) is Adjustment Trading: No Fixed Positions!

I previously contributed a guest article featured in the May edition expounding on using protective calls.

Since the electronic magazine's launch a short five months ago I've been quite pleased with the quality and relevance of each article. If you haven't yet checked it out you can get to their website using the ad on the left side of Tyler's Trading. Subscription to the magazine is risk free, as they offer a full refund if you are not completely satisfied within 30 days of subscribing. So what have you got to lose?

I've included last month's Table of Contents to give you an idea of the type of content included in the magazine.

Disclosure: I do receive a small referral fee for those signing up for Expiring Monthly through Tyler's Trading.

Wednesday, July 14, 2010

GOOG, What Volatility Bid Up?

In usual fashion Google is slated to report earnings on Thursday night, one day prior to earnings expiration. In Monday's Earnings Season Primer I made the assertion that option premiums get bid up (causing a rise in volatility) into earnings as market participants aggressively buy options to game the gap. This typically causes a notable discrepancy between implied and historical volatility levels just before the announcement.

So that's what GOOG has going, right?

Wrong.

A glance at GOOG's vol chart shows implied vol and historical (20 day) virtually inline. Notice how the last four earnings announcement saw the IV-HV difference peak pre-earnings (white arrows). This go around... not so much. What gives?
[Source: Livevol Pro]

Well, as noted yesterday, volatility has come in quite a bit across the board concurrent with the markets rally this week. That could certainly be one factor influencing GOOG's vol decline over the past few days.

Maybe its merely a reflection of the options mart not expecting much movement out of this search engine behemoth. I had that thought myself, but let's play devils advocate and throw out one more idea-

Keep in mind the IV-HV difference involves two variables, not one. Perhaps it's not so much that implied vol is low as much as it is historical volatility being high. After all, IV has sat around 32% in all of the last four earnings announcements for GOOG, making its current value pretty typical around this time. Since GOOG so conveniently reports right before expiration, it's easy to determine the expected move using the front month straddle. Right now the July 490 straddle is trading around $23- basically pricing in a 5% move.

I've already sung their praises in my What Will They Think of Next post, but allow me to once again express my excitement with Livevol Pro's volatility tools. I consider their platform a staple when it comes to analyzing earnings plays. If you haven't checked them out you can access their site using the advertisement on the side of my blog.

Disclosure: This should go without saying, but from the redundancy department of redundancy, LiveVol Pro is an advertiser on Tyler's Trading.

For related posts, readers can check out:
The Cycle of Implied Volatility
Finding Volatility
GOOG, I'm Feeling Lucky

Tuesday, July 13, 2010

A Volatility Inflection Point?

Wasn't it just last week the VIX was knocking on the door of 40? In the words of Michael Scott, "Oh how the turns have tabled." Over the past month the VIX has been like a yo-yo bouncing between overbought and oversold levels quite rapidly. Can you say mean reversion? Any chartist worth their salt could probably make the case we may be once again near an inflection point (click image to enlarge).
So how about playing a short term pop in the VIX with some short puts? With July expiration on the horizon for VIX options (next Wed.), there may be some worth selling.

Since the futures converge to the cash at expiration, we can reasonably expect the July futures to track the VIX Index relatively closely over the coming week. This is primarily why it's a bit easier to play VIX options close to expiration as they tend to be much more sensitive to day to day moves in the cash. Currently the VIX sits around 24.50 while the July futures reside at 25.85. Of the OTM July puts currently available, the 24 and 25 strike are really the only ones in play.

Suppose we took the lower credit, higher probability route and sold the July 24's for $60. Provided the VIX settles above 24 at July expiration we stand to gain $60. Though the theoretical risk with short puts is unlimited, you have to ask yourself how much lower you really think the VIX is likely to go in the next week. As for myself, I say not much.

Consider the risk graph below:

Source: [MachTrader]

For related posts, readers can check out:
VIX Settlement and Term Structure
Settlin' Them VIX Options
VIX Options
Lessons Learned from a VIX Put Matrix

Monday, July 12, 2010

Earnings Season Primer

With tonight's report from Alcoa, earnings season is officially upon us. Last time I checked AA was up 3% after hours, so it seems the market liked the announcement. What exactly was their revenue and EPS you ask? Well, beats me. All I care about is the price action. Leave the actual report and fundamental hullabaloo to number crunchers smarter than me.

In the past I've done my fair share of earnings play posts. Matter of fact, earnings plays have almost received the most face time on Tyler's Trading, coming in at number three within my labels widget just behind the SPX and VIX. So perhaps I'll dust off the 'ole earnings playbook and take a look at a few of the bigger names this go around. For those inclined to try their luck at gaming the earnings gap, keep these three truisms in mind:

1. Implied volatility is virtually always elevated into earnings as the option market seeks to adequately price in the magnitude of the earnings gap.

2. Implied volatility drops precipitously following earnings as options revert back to pricing in a stock's normal volatility.

3. Volatility sellers have the edge going into earnings. More times than not short vol strategies will yield a profit while long vol plays result in a loss. The fly in the ointment arises when assessing the average gain versus loss. Take short strangles for instance. Though you'll probably win roughly 2/3 of the time, the occasional loss can quickly overwhelm your gains. In the long run selling volatility into earnings is likely to be a zero sum game. In the end, trading them profitably comes down to proper position sizing, sound risk management, and a dash of good fortune.

For other earnings related posts, readers can check out:
Earnings... The Wrench in the Theta Clock
Volatility Crush
Lessons Learned From a Trip to the Woodshed
Wildest Dream of Worst Nightmare

Condor Rolls and Strangle Musings

Last week's sparse posting (ok, non-existent) was due to being away on vacation. Now that I'm back in the saddle things should return to normal. Let's kick things off with my response to a condor question from David:

My position is this: I sell iron condors on SPY, GLD, USO and selected world currencies each month. For risk control, I've used diversification among market strikes, expiry months, as well as the natural protection offered by the condors. Recently I've been wrestling with the trade-offs between iron condors and strangles, and, for me, they come down to the relative merits of the defensive techniques. (I know there are also differences in terms of margin and the emotional comfort from having protective strikes). Most months, I just want to roll when the short strike is threatened rather than buy extra protection. So, with this in mind, my questions are:

1. When is the best time to roll (is it better to roll early- which means it's cheaper but often unnecessary- or is it personal preference, or just too hard to give a simple answer?)
2. Is it easier/harder/the same to roll naked options instead of spreads (lower commissions, less loss from bid/ask spreads, less problems with liquidity).

At this stage I'm leaning towards switching to strangles, selling roughly 1.25 standard deviations out, and rolling the threatened strike when it approaches at-the-money. This would be necessary roughly 50% of the time, and if I sell a few extra contracts when I roll, I can get that side to net out to about zero. I then just book a profit from the other side of the strangle. Any thoughts you have would be greatly appreciated.

Regards,
David

Thanks for the questions David. Let's start with the first one. There is no best time to roll in my opinion. No matter which technique you choose (rolling early or later), you will inevitably face scenarios where the adjustment either proved unnecessary or resulted in more losses than had you simply exited the original trade. At the end of the day you've got to choose which technique best fits your personal preference and risk tolerance. Perhaps you've explored this before, but you may consider rolling in stages particularly if you have a larger position on. I've found staggering these adjustments more psychologically appealing versus the all-or-none approach; a nice compromise to those dithering on whether to roll or not. So, if you're short ten put spreads and the stock drops to a pre-determined threshold, rather than rolling all ten spreads, perhaps you roll three or five and then roll the rest later if needed.

From the quality of your question and explanation, I suspect you already know the main dilemmas with rolling. The key at this point is to settle on the one technique you find most appealing and put it to the test.

As for your second question- You've done a commendable job listing the usual suspects when it comes to the differences between the two. In terms of the mechanics of rolling, I can't really think of any additional differences off the top of my head, other than what you've mentioned.

Now, on to the short strangles. They can be quite alluring to those only focused on potential reward. Compared to the condor, you've got more potential reward (higher net credit), less commission, less slippage,and probably easier fills (as you basically outlined previously). However, with the higher reward comes higher risk. The elevated gamma risk is probably the most treacherous. I've seen trader's focusing on short strangles attempt to mitigate the additional gamma risk one of two ways (or both).

1. Use smaller position size. If you're used to selling a ten lot of condors, perhaps you would only sell a five lot of strangles.
2. Use longer dated options. As opposed to selling front month strangles, you may opt for second or third month options. By going out in time you can typically sell options further out-of-the-money (gaining a larger profit zone) while reducing the net gamma of the trade.

One final point- be cautious with increasing your contract size when rolling just to try to get back to even. That's a slippery slope that can turn quite painful if the stock continues to move adversely.

Sunday, July 4, 2010

Hedging with Calendars

In last week's Rollin with My Puts post, we reviewed rolling long SPY puts into verticals to partially hedge against a rally in the SPY. Today's post explores another alternative worth considering - rolling into calendars. Within the post the intial trade was outlined as follows:

"Suppose we purchased a SPY August 110 put option for $4.50 on June 23rd when the SPY was trading around $109. Given the precipitous fall in the market coupled with the sharp volatility surge over the last week, the put option has risen in value giving us a $280 unrealized gain."

Consider the position's risk graph below (click image to enlarge):

[Source: MachTrader]

Since last Wednesday, the put has further increased $150 placing the current unrealized gain around $430. Instead of shorting a lower strike Aug put against our position (rolling to a vertical), how about selling a July put? Suppose we sell the July 102 put for $2.15. Consider the new position's risk graph with the change in delta, theta, and vega:

Per the delta, the directional exposure was cut in half from -77 to -30. Theta has flipped from negative to positive, making the passage of time now a benefit to the trade. Finally, the trades exposure to volatility has been notably reduced as shown by the lower position Vega.

In summary, traders holding profitable put positions may consider rolling to verticals or calendars when wanting to hedge their risk against an adverse move. Whether the short option provides a large or small hedge is largely dependent on the strike price you choose to sell. In today's example we opted to sell a put eight strikes below the long put option (102 vs. 110). Where we seeking a larger hedge we may have considered selling a higher strike put such as the 104 or 105. Risk graphs prove quite effective when analyzing the net effect of selling one strike versus another. Be sure to use them as needed.

For related posts, readers can check out:
Adjustment Trading and the Salvation Syndrome
Utility of a Risk Graph
Graphing an Option's Evolution

Thursday, July 1, 2010

Ruh Roh

On the initial retest of 1040 back on June 7th, I offered up an SPX chart with potential downside targets in my post titled On the Brink. Well, after holding the low and taking a one month detour the SPX has once again returned to this infamous line in the sand. Though this time the bears came back with a vengeance and finally mustered the strength to breach this long time support level. The aforementioned detour turned out to be the formation of the right shoulder of a longer term head and shoulders pattern six months in the making. Rather than highlighting potential fib levels as displayed last month, today's graphic focuses on the topping pattern recently completed with two potential downside targets - the prior key resistance of 950 and implied target of the head and shoulder pattern. It strains the obvious to point this out, but keep in mind these are longer term levels to watch out for and aren't necessarily in play over the next few days (click image to enlarge).
[Source: MachTrader]

For related posts readers can check out:
Head & Shoulders, Knees and Toes
Lines in the Sand