Tyler's Trading

We're Moving!

2010-09-27T07:51:00.000-07:00

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, tylerstrading.blogspot.com is simply becoming www.tylerstrading.com. I'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 www.tylerstrading.com

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: rtylercraig@comcast.net

Low Volatility, a Siren Song?

2010-09-23T12:15:00.000-07:00

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

The Oil Angle

2010-09-21T08:06:00.000-07:00

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:

Time to Catch a Falling Knife?

Rolling With Crude Oil

Bare Naked Oil Puts

The SLV Lining

2010-09-20T08:18:00.000-07:00

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:

Stealth Rally

IVolatility Trading Digest Blog

Volatility Comparison Charts

2010-09-17T07:41:00.000-07:00

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?

It's Settled

2010-09-15T08:02:00.000-07:00

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:

Expiration and the Resolution of our VIX adVentures

VIX Expiration and Term Structure

VIX Settlement and Term Structure

Stealth Rally

2010-09-14T08:18:00.000-07:00

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:

Breaking Down a Put Spread

Time to Shine?

Gaming the Gold Bugs Redux

I've Got That Contrarian In Me

2010-09-13T09:09:00.000-07:00

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:

BattleGround

Bulls Bid-up Black Gold

Risk Rockets and the Strategic Exit

The Dynamics of Time Decay

2010-09-10T08:22:00.000-07:00

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:
Theta
Greeks
Gamma vs. Theta Part I
Gamma vs. Theta Part II

The Impending VIX Expiration

2010-09-09T07:43:00.000-07:00

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

Condor Evolution

2010-09-08T07:49:00.000-07:00

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]

The Case for the Condor

2010-09-07T06:46:00.000-07:00

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

Call Spread Conversations

2010-09-03T06:44:00.000-07:00

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

Volatility Spankin'

2010-09-01T07:18:00.000-07:00

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

Battleground

2010-08-31T07:25:00.000-07:00

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

It's All Relative

2010-08-30T07:27:00.000-07:00

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 ETFreplay.com (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: [ETFreplay.com]

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

Fading Away

2010-08-25T08:18:00.000-07:00

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).

Source: [MachTrader]

Rolls... Fresh Out the Oven

2010-08-24T06:57:00.000-07:00

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

What's the Game Plan?

2010-08-23T06:08:00.000-07:00

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.

Expiration and the Resolution of our VIX adVentures.

2010-08-17T16:34:00.000-07:00

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

Rough Seas Ahead?

2010-08-16T08:42:00.000-07:00

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.

The Tale of the VIX and Mr. Upper B.

2010-08-13T06:31:00.000-07:00

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

Viewer Mail - Long Call/Short Put Combo

2010-08-12T07:03:00.000-07:00

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

Hey Blockbuster, Eat My Dust...

2010-08-11T06:14:00.000-07:00

... 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

Stock Replacement Strike Selection

2010-08-10T06:27:00.000-07:00

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
Delta

Flys... of the Butter Variety

2010-08-09T06:18:00.000-07:00

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

Odds of Assignment

2010-08-05T06:22:00.000-07:00

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.

Rhyme and Reason

2010-08-04T07:05:00.000-07:00

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

Bulls Bid-up Black Gold

2010-08-02T12:23:00.000-07:00

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

2010-08-02T07:02:00.000-07:00

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

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

2010-07-29T06:48:00.000-07:00

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.

The Effectiveness of the 50 MA

2010-07-28T06:44:00.000-07:00

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.

The Nifty Fifty

2010-07-27T07:15:00.000-07:00

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...

The Rare Earnings Win-Win

2010-07-26T06:28:00.000-07:00

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

Vol Sellers Delight

2010-07-22T06:59:00.000-07:00

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]

For related posts, readers can check out:
Implied Vol vs. Historical Vol
The Cycle of Implied Volatility
Strangles vs. Iron Condors

VIX Expiration and Term Structure

2010-07-21T09:54:00.000-07:00

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

The Big AAPL

2010-07-20T08:59:00.000-07:00

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!

2010-07-20T06:21:00.000-07:00

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-

Expiring Monthly Guest Article

2010-07-19T06:33:00.000-07:00

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.

GOOG, What Volatility Bid Up?

2010-07-14T14:00:00.000-07:00

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

A Volatility Inflection Point?

2010-07-13T14:23:00.000-07:00

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

Earnings Season Primer

2010-07-12T16:29:00.000-07:00

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

2010-07-12T06:10:00.000-07:00

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.

Hedging with Calendars

2010-07-04T12:29:00.000-07:00

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

Ruh Roh

2010-07-01T06:48:00.000-07:00

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

Rollin with My Puts

2010-06-30T06:56:00.000-07:00

I received another question, this time from tjktrader, regarding how to manage long put positions when/if the market moves adversely. As is typically the case there isn't always one right way, but let's review a few adjustment ideas worth considering when playing with puts. The adjustments fall into two camps- ones you may use when the underlying moves adversely from the get-go causing the put to lose money and ones you may use once you've accumulated a decent chunk of profits on the put. The latter camp will be in focus today.

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 to $7.30 giving us a $280 unrealized gain. Not too shabby! Consider the risk graph displayed below. In this situation, how might a trader adjust the put to protect or hedge him/herself in case the SPY catches a bid and rallies back strong?

[Source: MachTrader]

First, adhere to the K.I.S.S. method and just sell the put to exit the trade. If you're of the opinion the market may bounce back strong and fear coughing up your hard earned gains, then there's nothing wrong with jumping ship with your captured booty.

Second, roll into a vertical put spread by selling a lower strike Aug put. Selling the lower strike put not only helps hedge your delta risk, but also theta and vega risk. Right now there are three ways you could start to give back profits: a rise in SPY, a drop in implied volatility, time decay. Suppose you sell the Aug 105 put for $4.60. Consider your new position in the risk graph below:
The delta risk has dropped from 70 to 20, theta has flipped from hurting your position to helping and your exposure to volatility has been largely eliminated. In addition, you can continue to accumulate profits up until about $510 and are guaranteed to capture at least a $10 profit regardless of how high the SPY may rally.

Yet another adjustments worth consideration is rolling to some type of calendar by selling a July option against the August put. We'll explore one such example tomorrow so stay tuned...

Risk Rockets and the Strategic Exit

2010-06-29T06:34:00.000-07:00

I received a thoughtful question regarding my exit strategy on the SPY risk rocket introduced in Fire Up the Boosters. Those familiar with the original post will recall we entered this bullish play to exploit the breakout over $111 in the SPY. The initial target was $113.50 or one ATR above the entry price. The trade turned out to be a heart-breaker as the SPY made a healthy attempt at following through to the upside but fell just shy of the target when it topped out at $113.20.

After coming within a hairs breadth of capturing the profit, and seeing last Monday's gap get sold into with a vengeance, I opted to bail when the SPY returned to its breakout point of $111. It obviously would have been nice had I adjusted right on the open on Monday when the SPY was close to my target, but hey, hindsight's 20-20 (click chart to enlarge).

[Source: MachTrader]

While I had a chance to bail close to my break-even point in this scenario, what might traders do if the stock moves adversely from the get-go on this type of play? My typical default exit plan for virtually any and all directional bullish plays is to bail once I've been proven wrong. When trading based off of a price pattern, such as a breakout, being proven wrong usually occurs when the pattern fails. I usually draw a line in the sand under some type of support level and declare myself wrong if that level gets taken out.

As they say, there's nothing wrong with being wrong... there is something wrong with staying wrong.

I suppose trader's could hedge the risk rocket by selling in-the-money calls when the underlying moves south. Though in my experience most trader's are better off just exiting since hedging opens up a whole new can of worms.

For related posts, readers can check out:
B-B-Breakout
Evolution of a Bullish Risk Rocket
Adjustment Thinking and the Salvation Syndrome

EBAY... No Bids?

2010-06-27T21:09:00.000-07:00

After breaking down selling put spreads, how about a few thoughts on buying them? Recently EBAY seems to have fallen out of favor as its stock price has experienced notable weakness relative to the tech sector and the overall market. What might be a strategic way of positioning oneself to profit from continued weakness in this online shopping mall? Options Action suggests purchasing an August 21-17 put spread for $1.00. Buying a put spread (also commonly, and perhaps redundantly, referred to as a bear put spread) consists of simultaneously buying a higher strike put while selling a lower strike put in the same month (click image to enlarge).

In the case of the EBAY spread, the best case scenario occurs if it resides beneath $17 by August expiration. The maximum profit for long put vertical spreads is equal to the distance between the strikes ($4 in this case) less the debit paid to enter. Consider the risk graphs below:

[Source: MachTrader]

One question worth considering is whether or not it is advantageous to sell the Aug 17 put which caps the profit potential. Why not just buy the Aug 21 put outright and have unlimited profit potential? The typical rationale for the superiority of the spread is it cheapens the trade while also hedging time and volatility risk. The problem I see with this particular spread on EBAY is the Aug 17 put only reduces the trade by $.25 When entering directional spreads I prefer to have the short option reduce the overall cost by around 1/3. At $.25 or about 1/5 the value of the long Aug 21 put, the Aug 17 put falls just a bit short. Shorting the 18 put is probably more up my alley.

Like most practitioners of technical analysis, I'm a fan of waiting to pull the trigger until after I have some type of catalyst. With EBAY currently sitting at long term technical support around $20.50, I'd prefer to see a breakdown before plunging into this type of play.

Breaking Down a Put Spread

2010-06-23T17:31:00.000-07:00

Suppose you like the current fundamental and technical outlook on gold and are considering throwing in your lot with the ever hopeful gold bugs. But with the SPDR Gold Shares (GLD) trading at $121 per share, let's say you're a bit skittish at the hefty price tag. While bullish risk rockets or other long stock strategies may be outside your price range, the cheaper vertical spreads may be an alternative worth your consideration. Let's breakdown an out-of-the money put vertical sell on GLD.

In choosing which month to use when structuring this play, some traders opt for front month options which offer an alluring higher rate of time decay. But remember these short term options aren't always sunshine and lolly pops, as they also include the often forgotten (or at least downplayed) gamma risk. Those favoring lower gamma risk over a higher theta typically prefer using longer dated options such as two or three months out. We'll go ahead and use August in today's example.

When it comes to strike selection, traders are faced with the dilemma of either going for a higher net credit and lower probability of profit or a lower credit and higher probability of profit. Suppose we settle on a happy medium between the two by going far enough out-of-the-money to feel comfortable with the profit zone, but close enough to still receive a sufficient return. Consider the risk graph of the Aug 115-110 put spread below.

[Source: MachTrader]

Provided GLD remains above $115, we stand to gain $89. While traders can certainly hold to expiration to capture the whole enchilada, it's usually prudent to exit when the majority of the profit has been achieved.

For related posts, readers can check out:
Ratios, Ratios, and More Ratios
Public Enemy #1
Time to Shine?

The Ascension in Gold

2010-06-18T06:45:00.000-07:00

Friday's surge in gold served as yet another breakout in a long line of bullish price patterns over the last few years. Today's chart highlights a few key technical levels the SPDR Gold Shares ETF has breached in its resilient march to recent highs. Whether or not the current breakout is followed by as strong of a run as past breaks remains to be seen. If history is any indication, it has not paid to bet against this pup when exhibiting this type of pattern.

[Source: MachTrader]

Friday's strength bode well for our GLD 121-124-127 butterfly as outlined in Rolling on the Fly. With a pop to $123, GLD settled nicely into our profit zone. While it would have been nice to have seen it nestle close to $124 into the close, it's rare to throw on a butterfly and see the stock pin right at the middle strike. Trader's using butterflies would be well served by learning to take partial profits.

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

Fire Up the Boosters

2010-06-17T17:14:00.000-07:00

Like most chartists, I'm continually on the lookout for quality patterns stacking the odds in my favor while providing favorable risk/reward entries. Entering the market at random times is not only silly, it's usually a one way ticket to the poorhouse. Whether you're an Elliot Wave practitioner, a Fibonnaci fanatic, or a volatility and sentiment analyzer, we're all attempting to find an exploitable edge and bring order to the seemingly random market. All too often traders miss the mark by bouncing from one trading style to another instead of honing in on one approach. Don't make the mistake of becoming a jack of all trades and master of none. As I've mentioned before I'm a simple man when it comes to technical analysis and believe that less is more. Usually the cleaner the chart the better.

Speaking of strategic entries, I'm thinking the market may have provided participants wanting to join the bullish throng with one such entry point during Tuesday's breakout. I took the opportunity to enter a bullish risk rocket on the SPY during the surge in anticipation of some more upside over the coming days. Suppose we purchased 100 shares at $111 and bought two July 113 calls for $1.65 apiece (click image to enlarge).

As is typically the case with these risk rockets, we're looking for a one average true range (ATR) profit before unloading the stock. At trade inception the SPY had an ATR around $2.50, putting our profit target at $113.50 (111+2.50). Once the target is reached and the gain on the stock locked in, we'll consider rolling the remaining calls to some type of risk free spread. I'll follow up with an update when needed.

[Addendum: The exit for today's SPY Risk Rocket can be found here]

For related posts, readers can check out:
Adjustment Thinking and the Salvation Syndrome
The Sling Shot
Risk Rocket

VIX Settlement and Term Structure

2010-06-16T07:37:00.000-07:00

June VIX options expired today with a settlement value of 26.11. Long time readers know the settlement price can be viewed a couple different ways. First, the CBOE usually publishes the price within a few hours of the open on its Index Settlement Value page. Second, you can view the price in a charting platform using the VIX's settlement ticker symbol $VRO. If you take the charting route, keep in mind the settlement value is simply one value per month. Since it doesn't have an Open, Close, High, or Low, you can't view it very well on a bar or candle chart. So stick to a line chart and you should be fine. One of the benefits of using the chart versus the CBOE page is having the ability to simultaneously see past VIX settlement values to better grasp how the VIX has progressed over time.

[Source: MachTrader]

A survey of the current volatility landscape shows the VIX futures in contango with the July's at a 2.5 point premium and the Aug's at a 3.35 point premium to the VIX cash. Given the precipitous drop in volatility this week, it's not surprising the futures are now above the cash and in contango. Remember, the futures are pricing in any type of mean reversion expected to take place between now and then. A quick assessment of the term structure simply shows us the expected mean is higher than the current VIX cash. Whether or not the futures have it right remains to be seen (click image to enlarge).

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

B-B-B-Breakout

2010-06-16T06:20:00.000-07:00

After remaining range bound for seventeen trading days, the SPX was finally able to muster enough momentum to breakout. While it remains to be seen how much follow through we experience over the coming days, the bulls definitely scored a victory with yesterday's pop which did some notable technical damage to the downtrend in place over the last two months. Just as we looked at potential downside targets in last week's On the Brink, let's highlight a few key resistance levels looming overhead.

[Source: MachTrader]

Fibonnaci traders considering retracement levels between the April 1220 high and June 1040 low are likely to point out the 50% and 61.8% retracements residing at 1130 and 1150. Skeptics of the whole fib approach could consider the 50 day moving average around 1140 and especially the prior pivot high at 1170. Either way, from current levels the SPX has room to run if it wants to.

One potential fly in the ointment I see that may sour any immediate follow through to yesterday's breakout is the fact that the SPX is up 75 points in six days. It wouldn't surprise me to see a bit of churning to digest this overbought pressure. What I, as well as any other chartists calling yesterday a breakout, would not want to see is a plunge right back into the trading range.

For related posts, readers can check out:
Retracements
The Market is Vewy Vewy Quiet
Old King Kol

Exiting the Volatility Fray

2010-06-15T09:02:00.000-07:00

Last week's Entering the Volatility Fray marked my first stab at playing VXX options. After experimenting with a few different strategies, I settled on call ratio spreads. Three key factors went into my decision. First, VXX options had some pretty steep upside skew making the OTM calls relatively expensive. Second, volatility had reached lofty enough levels to make me a seller. Third, call ratio spreads give me quite a bit of leeway due to the large profit zone.

I ended up exiting the trade yesterday once I had captured the majority of the original credit received. I originally sold the spread for $140 credit and exited yesterday at $20. With a scant $20 left and about five weeks remaining until expiration, it was a no brainer exit. Since the SPX held the 1050 level and staged a nice little rally, we've seen fear dissipate out of the markets a bit. Not surprisingly, VXX stock has come in and has seen an easing in demand for its out-of-the money calls. Take a look at the following two skew charts displaying the vol levels of the July 40 strike calls at trade inception as well as when I exited.

[Source: Livevol Pro]

I originally sold the 40 calls when they traded at an implied vol of 108%. The 7 point drop to 101% coupled with the notable drop in VXX stock quickly depressed the calls involved in the trade providing me with a swift exit.

For related posts, readers can check out:
Volatility Skew and Ratio Spreads
Gaming the Gold Bugs

From One Extreme to the Other

2010-06-14T08:51:00.000-07:00

[Source: MachTrader]

Since illustrating 1050 and 1105 as two key levels in June 2nd's Lines in the Sand post, this trading range has proved quite resilient. Just as the bulls thought a break to the upside was imminent on the eve of the Employment Report, the bears (including myself) thought 1050 was toast last week. But alas, both prognostications have proven unfruitful so far. I suppose this illustrates the importance of waiting for confirmation. While it's fair to speculate as to whether we're going to breakout or not, it's usually prudent to wait for some type of price confirmation before allocating any capital to the idea.

Stock Repair to the Rescue

2010-06-14T06:26:00.000-07:00

To say BP has been beat silly over the last month is quite an understatement to say the least. Trying to pick a bottom in this has been like nailing jello to a tree and serves as yet another example of the futility of bottom fishing. So what about those longer term investors who purchased shares in the $50 range and find themselves way underwater? While my first inclination is to question their sanity for allowing a position to drop 50% without jumping ship, let's see if we can lend a helping hand by outlining a stock repair strategy suggested by the Options Action gang on Friday.

Most traditional investors wanting to remain long BP in an attempt to recoup losses really only have two choices. First, they could hold on and hope BP rises back north of $50 - a scenario I find highly unlikely anytime soon. Second, they could double down by purchasing more shares at current levels. The advantage of doubling down is dropping their average cost basis (break-even) to the low 40's. While it is smart to attempt lowering the break-even to increase your probability of recouping loss, doubling your risk at the same time can be a tough pill to swallow. Wouldn't it be nice to lower the break-even without adding risk? Look no further than the stock repair strategy.

This repair strategy can be entered by simply adding a 1x2 call ratio spread to your long stock position. You can think of it as selling a covered call and buying a call spread simultaneously. Suppose our original purchase price of BP was $50 giving us the following risk graph:

[Source: MachTrader]

We have a current unrealized loss of $1900 and need a $19 rise to reach our break-even point.

To enter a repair strategy we could buy one Oct. 36 call for $4.30 while selling two Oct. 41 calls for $2.25 apiece. We're essentially selling an Oct. 41 covered call and buying an Oct. 36-41 call spread. Because the credit received from selling the two 41 calls was sufficient to pay for the long 36 call, this repair strategy can be entered at no additional out of pocket cost. Now let's see if it improved our break-even by assessing the new risk graph:

In the new position, we now only need a rise to $41 instead of $50 to recoup the loss. Though it is ideal to recoup the entire loss, this specific repair falls $280 short. But, let's be honest. Any trader in their right mind would love to turn a $1900 loss into $280. Keep in mind this strategy does nothing to decreasing remaining downside risk, so it's not really a hedging strategy as much as it is a repair helping you make money back quicker.

For a more detailed look at the stock repair strategy, CBOE has a solid write up than can be found here.

Rolling on the Fly

2010-06-10T07:35:00.001-07:00

Due to GLD's recent failure to breakout to new highs, I rolled the call spread outlined in Evolution of a Bullish Risk Rocket to a butterfly. Those familiar with the original post are aware that we were already in a risk free June 121-124 bull call spread. In fact, our minimum reward came out to $132. Given the already advantageous position we were in, why bother with further adjusting into a butterfly? Though I could cite several added benefits, let's focus on two.

1. A Higher Minimum Reward: In order to roll the long call spread to a fly, we added a short call spread. The credit received from selling this spread directly increases our minimum reward.
2. Profit Zone Shifts: The fly's risk graph provides superior profits at GLD's current price versus the original call spread. This downward shift of the graph puts me in a better position if GLD fails to rise above 124 by June expiration.

Consider the original call spread's risk graph:

[Source: MachTrader]

Consider the new butterfly's graph:

The only outcome that will result in the fly under performing the original call spread will be if GLD rises past $125 by next Friday (June expiration). While anything is possible, it's fair to say a surge of that magnitude with only a week remaining is highly unlikely.

For related posts, readers can check out:
Adjustment Thinking and the Salvation Syndrome
Decision Trees
The Sling Shot

An Option Sellers Dilemma

2010-06-09T12:09:00.000-07:00

Let's tackle a question I received from Dave earlier today.

You've mentioned before that it might not be a good idea to hold options into expiration due to gamma risk. Do you ever just let them expire worthless or do you always exit? I have two bear call spreads, one is a little over $10 OTM while the other is $15 OTM. Both are virtually worthless, but it would cost $.10 plus commission to close them. In this case would you hold to expiration to avoid commission or do you never hold into expiration?

This is a scenario that faces all option sellers at one point or another. Whether you sell covered calls, naked puts, or credit spreads, you'll eventually face the dilemma of deciding whether to buy back short options when you've captured the majority of the profit or ride to expiration in an effort to lock in the last few pennies. The obvious allure of hanging on until expiration is capturing that last $.10 plus avoiding paying the pesky commissions which are unfortunately a necessary evil. As you mention, the treacherous risk lurking in the shadows around expiration is gamma. While it seems like a "sure thing" that your bear call spreads will expire worthless, the market has a merciless track record of reminding traders there's no such thing as a sure thing. Don't rule out the chance that the stock you're trading could make a kamikaze run for your short call spread over the remaining week. Due to the high gamma of short term options, they can increase rapidly in price if they start to move close to the money.

Traders who continually hold short options into expiration will inevitably face a scenario where they end up having to buy back those $.05 or $.10 options for $1 or $2. All it takes is one huge adverse move close to expiration to wipe out the additional few bucks you gained from the past five or ten trades. After experiencing a few of these gut wrenching disasters, most experienced traders opt to simply avoid the high gamma drama that plays out close to expiration by closing short options early. They value the peace of mind that comes with this approach more than the extra few bucks they may make by riding to expiration. At the end of the day, it's really up to you as to which route best fits your risk tolerance.

For related posts, readers can check out:
Public Enemy #1
Gamma vs. Theta
Gamma vs. Theta II

Entering the Volatility Fray

2010-06-08T16:24:00.000-07:00

Traders wishing to trade volatility gained yet another weapon to their arsenal with the CBOE's recent roll out of options on the iPath S&P 500 VIX Short-Term Futures ETN (VXX) and the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ). As with any new trading product, I've been watching the trading volumes on both to see what type of traction they gain and whether or not they offer sufficient liquidity to merit a place in my personal trading toolbox. In assessing liquidity I'm primarily interested in whether or not the vehicle under scrutiny offers a tight enough bid-ask spread. If the spreads are wide enough to drive a Mack truck through, I'm not interested. Perhaps we could pin up SPY options as the poster child since they offer super tight penny spreads due their tremendous liquidity.

Given the current status of the VXZ options, I wouldn't touch them with a ten foot pole. With the spreads as wide as they are, why bother? VXX options, on the other hand, are starting to look a bit more tempting. Like most semi-liquid options, the front month is seeing the most action and thus offering the tightest spreads. Currently the ATM June call is trading at $1.95 by $2.15. At $.20, the spread is certainly tight enough to warrant playing with in my opinion. Venturing further along the expiration curve offers less liquidity and wider spreads. I suspect as volume builds, we'll see the spreads continue to come in.

Currently we're seeing a decent amount of upside skew in VXX options, where higher strike calls are trading at higher vol levels than lower strike calls. Those familiar with VIX options shouldn't find this all that revealing as VIX options have historically seen a decent amount of upside vol skew due to the higher demand for OTM calls versus OTM puts. Consider the following skew chart of the VXX July options.

[Source: Livevol Pro]

Today marked my first attempt at trading VXX options. To exploit the relative expensiveness of the OTM calls as well as a neutral to bearish move in the underlying, I entered a July call ratio spread by buying a 37 call and selling two 40 calls.

[Source: MachTrader]

As long as we remain below 37 between now and July expiration, I stand to gain the net credit received at trade inception. A slow drift higher would also prove beneficial provided it doesn't occur too quick. Due to the extra short calls there is upside gamma risk if a continued rise in volatility gets out of hand. But given the already elevated state of volatility futures I'm relatively comfortable placing my bets we don't go that much higher over the next few weeks.

For related posts, readers can check out
Reflections on VXX
Goldman Sacked

The Lending Merry-Go-Round

2010-06-08T11:44:00.000-07:00

Confused about all the bailouts? Let's break 'em down...

On the Brink

2010-06-07T13:26:00.000-07:00

After holding firm for a few days, the lower line in the sand outlined in last week's post seems ready to give way. Though the bulls gave it a valiant effort trying to breach the 1105 SPX resistance level last week, the employment report ushered in yet another surge in selling pressure. With today's close of 1050, the SPX is knocking on the door of a breakdown below a significant weekly pivot. Assuming we see more follow through to the downside, this break will serve as yet one more nail in the market's technical deterioration coffin and would be the first time we've broken a weekly pivot low since the March 2009 Bear Market low.

Today's graphic highlight's a weekly chart of the S&P 500 with two sets of fibonnaci retracements displayed. The first set of fibs spans from the 2007 market top (1576) to the 2009 market bottom (666) and is displayed in blue. The other spans from the recent 2010 highs (1219) to the 2009 market bottom (666) and is displayed in dark green. While I'm not an avid fan of using fibonnaci retracements on smaller time frames, I do find them quite effective when identifying key levels that may act as support or resistance on the weekly chart. Following 1050, the next two downside targets on my radar are 1015 and 950 (click image to enlarge).

[Source: MachTrader]

Today's surge in gold certainly helped our GLD June 121-124 call spread outlined in Evolution of a Bullish Risk Rocket. If GLD is able to muster up another dollar or two rise we should be in prime position to roll into a butterfly or condor by adding a short call spread to our position.

For related posts, check out:
Retracements

Lines in the Sand

2010-06-02T09:41:00.001-07:00

After spoiling chartists with a clean and easily definable head and shoulders and bear retracement pattern over the last month, it seems the S&P has returned to murky waters. Since bottoming out last week the S&P 500 Index has thus far settled into a choppy range between 1050 and 1105. In my own attempt at simplifying charting I'm a staunch believer in the notion that less is more. I often use simple horizontal lines in highlighting key support or resistance levels. These lines in the sand represent pivotal points in the chart that if broken would change my short term outlook. Currently the two closest benchmarks reside at 1050 and 1105.

So long as we meander between these levels I will maintain my lack of conviction as to the direction of the next short to intermediate term move in the SPX. On the other hand, once we break above or below either level I'll be anticipating some follow through (click image to enlarge).

[Source: Mach Trader]

For related posts, readers can check out:
State of the Market
Head & Shoulders, Knees and Toes
Buy the Dips, Sell the Rips

Evolution of a Bullish Risk Rocket

2010-05-31T10:30:00.000-07:00

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

California

2010-05-25T07:30:00.000-07:00

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.

Public Enemy #1

2010-05-20T15:26:00.001-07:00

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

Time to Catch a Falling Knife?

2010-05-19T16:13:00.000-07:00

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

2010-05-19T09:53:00.000-07:00

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.

[Source: MachTrader]

For past VIX expiration plays check out:
VIX Expiration on the Horizon
Fading Complacency
VIX Options Laid to Rest while the Cash Springs to Life

Ratios, Ratios, and more Ratios

2010-05-18T14:46:00.000-07:00

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

AAPL Options... A Steal or Too Rich?

2010-05-17T07:03:00.000-07:00

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

My question is regarding ivolatility.com 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

Blast Off...

2010-05-14T09:12:00.000-07:00

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]

Risk Rocket

2010-05-11T17:04:00.000-07:00

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.

Gamma Scalping Inquiry

2010-05-10T08:00:00.000-07:00

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?

Jon

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

RIMM and Gamma Scalping

2010-05-05T17:01:00.000-07:00

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.

Goldman Sacked

2010-05-04T06:56:00.000-07:00

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

State of the Market

2010-05-02T17:09:00.000-07:00

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.

Time to Shine?

2010-04-29T08:59:00.000-07:00

With Tuesday's free fall in equities came a rush into the supposed safety zone of gold. After lying dormant for five months, gold is knocking on the door of a potential breakout. Since December 2009, gold has found a home within the $100 point range between 1060 and 1160. Will this base serve as a launching pad for a breakout and resumption of its longer term uptrend? To further support this premise, those with a knack for chart reading may also be noticing the multi-month inverse head and shoulders pattern that is on the cusp of completion.

[Source: MachTrader]

How about considering selling a put spread on the SPDR Gold Shares (GLD) to take advantage of a continued rise in gold? With a mere three weeks remaining in the May expiration cycle there isn't much extrinsic value remaining. As such, I'd probably opt to use June options in constructing the put spread. Suppose we sell the June 110 put for $1.40 and buy the June 105 put for $.50. As long as GLD remains above $110 by June expiration, we're looking at a maximum reward of $90.

As is the nature of all OTM put spread, we have a relatively high probability of profit but a smaller risk/reward ratio. That said, a $90 return on $410 is still over a 20% return.

For related posts, readers can check out:
Previous GLD Posts
Bull Put Spreads

Volatility Spike and Ratio Spreads

2010-04-28T09:18:00.000-07:00

Yesterday's monster sell off ushered in a notable resurgence in fear. With a 30+% spike in the VIX, there certainly seemed to be a mad dash toward buying option premium. The 64K question is whether or not this upturn in volatility is a "one hit wonder" soon to subside, or whether it's a clarion call to the bears to come out from hibernation and start wreaking havoc on the market. No doubt time will tell which scenario ends up playing out. It will be interesting to see over the remainder of the week whether or not we get some significant follow through to the downside.

Provided Tuesday's sell off is a short lived event, the volatility ramp up is certainly providing some compelling opportunities. In Volatility Skew and Ratio Spreads I explored volatility skew and how to use ratio spreads to take advantage of potentially overpriced downside puts. Let's take a renewed look at the vol skew that has elevated over the last few days and construct a potential ratio spread.

A quick assessment of the SPY option chain shows lower strike puts trading at higher implied volatility levels than higher strike puts. From a volatility perspective we prefer to buy options trading at lower volatility levels and sell those trading at higher volatility levels.
We may consider structuring a ratio spread to exploit the relatively expensive OTM puts. Suppose we purchase a May 117 put for $150 and simultaneously short three May 113 puts for $240 ($80 x 3). Consider the risk graph below:

[Source: MachTrader]

The blue, red, and green lines display the affect of declining volatility. The upward shift shows the positive effect this could have on the trade. When entering a ratio spread, traders can modify the risk-reward by changing the ratio of long to short options. While some trader may opt to do a 1 x 2 spread, others may prefer a 1 x 3 spread. At the end of the day you need to assess the risk graph to ensure your comfortable with the potential risk inherent to the trade. While shorting 3 puts for every 1 you purchase offers a higher net credit, it also possesses more downside risk due to the additional short puts.

For related posts, readers can check out:
Larry McMillan on Volatility
Volatility Skew and SPY Ratio Spread Update
Gaming the Sell-off with Put Ratio Spreads

Betting on Casinos

2010-04-26T07:41:00.000-07:00

Amidst the market tear and bear boot stompin', one area exhibiting recent relative strength versus the broader markets is the gaming and casino industry. The likes of MGM, LVS, and WYNN are up from 15-30% over the last month alone. While I can't speak much to the fundamentals of these high rollers, it's tough not to like their recent price action (click image to enlarge).

[Source: Yahoo! Finance]

The Options Action gang concocted a bullish option strategy to exploit a continued rise in MGM stock. The play consisted of a short Jun 15 put and a long Jun 17.5- 20 call spread. After buying the call spread for $60 and receiving $110 for the short put, the trader would be left with $50 credit at trade inception.

That $50 represents the minimum profit potential if MGM remains above $15 by Jun expiration. The ideal scenario is for MGM to rise above $17.50 so the call spread will start to move in-the-money. The maximum profit zone comes into play over $20 at expiration.

[Source: MachTrader]

One variation to the suggested trade worth considering is simply selling the naked put and avoiding the call spread. Though the call spread increases your delta exposure and grants larger profits if MGM rises above $17.50 by expiration, it does reduce the overall net credit received. At the end of the day, there are numerous ways traders can construct bullish option positions. The key is to ensure one is comfortable with the risk-reward and pay off structure.

For related posts readers can check out:
Options Action
Delicious AAPL
Bull Call Spreads

Decision Trees

2010-04-22T12:50:00.000-07:00

At some point during a trader's learning curve they will undoubtedly be introduced to the idea of developing a trading plan. Achieving consistent results necessitates having a consistent approach. It is quite unrealistic to expect consistent returns month to month if you lack structure in your approach. While shooting from the hip or "winging it" may require less effort, it is usually a recipe for disaster in the long run. Each trader should have some type of method to the madness, a rhyme and reason as to their timing, trade, and risk management. A systematic approach has helped me in producing more consistent results.

While there are numerous ways to explain one's trading plan and outline the decision making process, one tool of worth I've found particularly useful with adjustment trading is a decision tree, such as the one displayed below:

Decision trees offer the ability to model potential trade adjustments based on changes in the underlying market. In the tree highlighted above I've displayed the Sling Shot trade mentioned in Tuesday's post with various adjustments worth considering. T1 represents the original trade, while T2 and T3 represent secondary and tertiary adjustments. The beauty of the decision tree lies in its flexibility, as it allows users the ability to create very simple or largely complex models.

I've also found them quite useful from an educational standpoint. It's proved much simpler to show the potential adjustments traders may make at various points in a trade as opposed to explaining them.

The Sling Shot

2010-04-20T11:26:00.000-07:00

Recently I've been playing around with a directional strategy, informally dubbed the "sling shot", that I was introduced to by one of my trading colleagues. It's a neat little strategy which incorporates some of the adjustment techniques introduced in Adjustment Thinking and the Salvation Syndrome as well as Adjusting in Action: Long Call to Call Spreads and can be used for those with a knack for forecasting price direction. In an attempt to exploit the bullish retracement in oil last week (as highlighted in Crude Retracement), I entered a sling shot on the United States Oil Fund (USO).

The structure of the trade involves simultaneously purchasing shares of stock and OTM call(s). Typically you unload the shares after achieving a 1 ATR profit. Ideally this 1 ATR profit pays for most, if not all, of the cost of the call options. In other words, we're using the profit from the stock portion of the trade to finance the purchase of the call options. Upon selling the shares of stock you could either remain long the calls or roll them into a spread to further reduce your risk. Let's take a look at the play in action using USO.
On April 13th, I purchase 100 shares of stock for $40.70 and 2 May 43 calls for $.55 apiece (click image to enlarge).
After rising around $1 (a little over 1 ATR) over the next day and a half, I sold the stock for a $100 profit. This $100 profit paid for all but $10 of the cost of the long 43 call options, which took the risk from virtually unlimited (due to the long stock) down to $10. Though I didn't lock in any gains, the adjustment succeeded in lowering the overall position cost and reducing risk.
If I was aggressively bullish on USO I could have simply remained in the long call options. However, given that I wasn't that bullish I instead opted to roll the long calls into a call spread by selling the May 45 call options for $.40 apiece. By receiving an additional $40 of premium, My $10 of risk remaining in the trade turned into a minimum reward of $30. This time the adjustment did lock in gains.

[Source: MachTrader]

Though USO has since dropped back in price resulting in giving back some of the unrealized gains, my original risk capital has been taken off the table. The crux of the trade as I see it is getting the first ATR move in your favor. Once you've locked in the profit on the stock, the risk-reward payoff as outlined in the risk graph improves dramatically. Going forward I'll periodically come back to the sling shot to shed further insight.

Covered Calls and the Oracle of Omaha

2010-04-16T07:07:00.000-07:00

Let's pop open the mailbag and tackle some viewer mail.

I bought 100 shares of BRK-B at $71 shortly after it split. I've been thinking about covered calls on the stock. I plan to hold it for several months and figured maybe I could sell the calls in the meantime. I expect the stock to stay pretty flat for a while, so doesn't it make a good candidate? Karen-
Hey Karen,

Evaluating covered call candidates is a two part process. Since they perform best in neutral to mildly bullish markets, I would first find a stock that fit that description. However, not all stagnant to mildly bullish trending stocks are going to work for covered calls. The second part of the process involves assessing the options chain to determine if there is a strike price that will provide sufficient premium to make the trade worthwhile. There are a couple problems that may crop up when trying to find the right option to sell. First, the strikes may be too far apart, which means you'll either have to sell a call option that is ITM (which cuts off any appreciation in the stock price) or one that is too far OTM (which may offer little premium).

The second issue that may arise is that of volatility. If the implied volatility of the options you're considering selling is too low, there may not be enough premium to make it worth your while. With this process in mind, let's take a stab at BRK-B (click to enlarge).

[Source: MachTrader]

You'll have to be the judge on whether or not the chart is neutral to mildly bullish. I'd say it looks more neutral, though it has rolled over a bit in the last month. Take note of the historical volatility displayed at the bottom of the chart. At 9%, BRK-B is definitely not a mover and a shaker (the post split ramp being the exception of course). As a result the options trade at pretty low implied volatility levels and therefore offer little premium when compared to the $80 you're shelling out to buy shares of stock.

One final issue worth mentioning is the availability of strikes. Due to its high share price, BRK.B only offers strikes every $5 apart. Given its low volatility a $5 move is quite large. Consequently, the OTM options don't offer much premium at all. In the May expiration cycle, the only strike in play is the 80 and it's only offering $1.50. The 85 strike is too far OTM and the 75 is too far ITM.

For related posts, readers are encouraged to check out:
Investigation of an Over-Write
Over-Writes: A Delta Perspective
Over-Writes: A Delta Perspective Take Two

RIMM Options on Sale?

2010-04-14T08:31:00.000-07:00

Though S&P options remain overpriced versus realized volatility, there are a few spots where implied volatility has come in enough to make buying options somewhat attractive. One such candidate is RIMM. Following its earnings announcement about two weeks ago, implied vol has dropped precipitously to around 30%. In finding evidence that options are cheap we could point out that this is a 52 week low in implied volatility, but truth is that's not saying much. Just about all options these days are seeing vol at 52 week lows. What is more noteworthy in RIMM's case is the fact that implied vol is right in-line or perhaps a tad low when compared to realized volatility.

Now to be fair, the earnings gap is still in the calculation of 20 day HV displayed below. As a result it's skewed higher than what it would be without the gap. However, excluding the gap, you're still looking at realized vol around 30% which is in-line with current option prices (click image to enlarge).

[Source: Livevol Pro]

Yet another sign that options are getting more attractive for buyers is the cyclical nature of RIMM volatility as seen over the past few earnings announcements. Usual within about a few weeks to a month following earnings, volatility has had a tendency to bottom.

Lest you think bottom fishing in volatility is a walk in the park, take a look at Adam Warner's write up regarding the fight between time decay and adequate price movement.

For related posts, readers are encouraged to check out:
The Tempest and Volatility Analysis
The Cycle of Implied Volatility

Crude Retracement

2010-04-13T06:44:00.000-07:00

After oscillating between $70 and $83 a barrel for 6 months, crude oil finally broke out of its trading range two weeks ago. After rallying to $87, crude has since experienced an orderly retracement back to its breakout point. If you subscribe to the notion that prior resistance becomes new support, this may be an area worth watching closely for bullish entries. If oil plunges right back into its old trading range, the validity of last week's breakout will be brought into question.

[Source: MachTrader]

For non-futures traders, the United States Oil Fund (USO) is probably your best bet for a proxy of crude oil. In my experience it's done a well enough job in tracking crude oil to make it a viable trading vehicle.

GOOG, I'm Feeling Lucky

2010-04-11T20:33:00.000-07:00

Looks like last week's Options Action had a perky Brit named Simon pinch hitting for Melissa Lee. Though he started out like a car salesman amped up on too much caffeine, he fortunately mellowed out as the show progressed. With a slew of earnings on tap next week, they offered up a few trade ideas to mull over. Could earnings be the catalyst to finally propel the market out of its sleepy grind higher? I think it's a decent thesis. I mean, how much lower can historical volatility get? At 7%, it's certainly not tough to bet it will rise at some point. It's timing the turn that can be uber tough though. As most of us know, complacency can linger for quite a while.

As is typically the case, Google has earnings the day before options expiration. With only one day remaining in the front month options and such a big potential move in the works, you can bet the April options will be trading at high volatility levels. Though the large premiums in 1 day options can be quite alluring, keep in mind flirting with gamma can get you a black eye before you know what hit you. Rather than deal with the high risk high reward inherent with April options, Options Action suggested making a directional bet by buying the June 560 put and selling the June 510 put for $15. As of Monday morning, the put spread was actually trading around $13.5, so we'll use that for the risk graph.

[Source: MachTrader]

Typically I'm not a fan of playing strong directional plays into earnings, but if I was going to take a stab at it, I do like the idea of using a spread versus buying options outright. As long time readers know, volatility gets sucked out of option premiums pretty quick following earnings. Using a spread helps to mitigate some of this volatility risk. Also, keep in mind GOOG options have a wider bid/ask spread, making it even more important to use limit orders and get a good execution.

For related posts, readings can check out:
Bear Put Spreads
Options Action

The Relativity of Volatility

2010-04-08T16:56:00.000-07:00

Apologies for the sparse posting as of late. My time has been eaten up by other endeavors leaving little room for nurturing my little corner of the blogosphere. Rest assured this next week will be more interesting as I've been tinkering with a few posts in my workshop of ideas. So how about kicking it off with a few volatility musings...

When analyzing volatility remember that there aren't really any absolutes. Take the VIX for example. While it would be nice to assert that the VIX is "low" when at 20 (cheap options) or "high" when at 30 (expensive options), the truth is its all relative. The VIX could be at a crazy low level like 10 and options could still be overpriced. On the other hand it could be in the stratosphere at 80 and options could still be underpriced. Whether implied vol was too high or too low when you entered an option trade depends on the volatility of the underlying throughout the duration of the trade. Suppose you think SPY options are cheap right now so you buy an ATM straddle. Currently the implied vol on the May 119 straddle is around 14.5%, which implies a little less than a 1% daily move should occur approximately 68% of the time in the SPY. That's a lot of numbers so read that last sentence again if you need to. Even though 14.5% vol seems cheap, what if the SPY is only able to muster up a .5% move on average each day (which coincidentally is pretty much happening right now)? Well, sorry charlie but you overpaid for that straddle. Though you looked at a low absolute number like 14% and made the assessment that options were a buy, reality is they were still a sell.

One lesson I can draw from my experience selling condors back in 2006 and 2007 is the fact that options' volatility can continue to be expensive even with the VIX sitting at barn burning low levels like 10. Between Oct 2006 and Feb 2007 the VIX found a nice home right around 10; a level which historically speaking is very low. How much volatility did the SPY actually realizes over the same time frame? About 7%, which made selling condors a lucrative proposition (click image to enlarge).

[Source: MachTrader]

This perhaps reiterates why it's beneficial to use a short term historical volatility reading like 10 or 21 days when assessing whether options seem cheap or expensive. It keeps us grounded in reality and serves as a useful benchmark for gauging what's happening in the here and now. While looking at the VIX now compared to 2008 certainly makes it seem like options are a steal of a deal, comparing it to recent realized volatility paints a different picture altogether.

Adjusting in Action: Long Call to Call Spread

2010-03-30T14:28:00.000-07:00

Last week's Adjustment Thinking and Salvation Syndrome post outlined some of the basic objectives of adjusting option positions. The two primary objectives were locking in gains or lowering the overall position cost and reducing or shifting risk. Since stock prices rarely move straight up or down in an orderly manner, those who maintain flexibility in their approach have an edge in producing long term profitability. As an aside, though the last sentence reflects the conventional wisdom I've subscribed to, the bullish run experienced over the last year certainly makes me give buy and hold a second thought.

Let's explore one such adjustment idea using call options on MEE (Massey Energy Corp). Suppose you decided to take advantage of the pullback that occurred in MEE from March 18-22 by purchasing a May 50 call for $4.00 on March 23rd. The net debit and max risk would be $4, the max reward unlimited, and the expiration break even $54.

As of yesterday, MEE had rallied roughly 8% and the call had increased in value to $6.70. Rather than selling the call option to capture the $2.70 gain, we may have considered rolling to a call spread by selling the May 55 call for $4.00. Since the premium received from the short May 55 call was sufficient to pay for the long May 50 call, our net debit and max risk was reduced from $4 to zero. The upside profit potential is also now capped at $500.

[Source: MachTrader]

By rolling our long call position to a call spread we've succeeded in lowering the overall position cost and reducing the risk. Due to the large rise in MEE stock, we were able to completely eliminate the potential risk in the trade. Keep in mind this will not always be the case. Oftentimes you'll be selling the higher strike call for less than what you purchased the original call. In the case of MEE, suppose we sold May 55 call for $3 instead of $4. Instead of reducing the risk from $4 to zero, it would have been reduced from $4 to $1.

Being able to roll a profitable long call to a small or no risk call spread assumes you first have the ability to turn a profit with a simple long call option- a feat easier said than done. If you are a trader that purchases straight call options from time to time, it may be worthwhile to consider adding the adjustment to a call spread into your trading plan.

Mail Time: Call Spreads and Assignment

2010-03-29T09:56:00.001-07:00

Hey Tyler. I purchased a July 240-250 call spread (bull call spread) for $4.80 on March 9^th when PCLN was right around 240. After PCLN rallied to $262, the short 250 call was $12 in-the-money. Rather than waiting closer to expiration to realize more profit, we decided to exit early to avoid being assigned. Even though PCLN rallied $12 above our call spread, we only made about $180. Could you give me your insight on what we did wrong or missed in the trade? Also, with so much time value left in the trade, what is your opinion on early assignment?

Thanks, Kevin-

For the call spread to reach maximum profit potential, it must lose all of its extrinsic (time) value. For this to occur 4 months prior to expiration (as we stand right now), the calls have to move deep enough ITM to lose all of their extrinsic value. When an ITM option loses all its extrinsic value and is trading at its intrinsic value, we say it’s trading “at parity”. You can consult a risk graph to assess how high PCLN would have to move before expiration for you to capture the majority of your profit. Given that you used July options which still have 4 months to expiry, PCLN would probably have to move up toward 290 for the call spread to be anywhere close to its max profit at this stage in the game.

The other scenario which would cause the call spread to lose its extrinsic value is time decay. As a slightly ITM call spread approaches expiration it will increase in value bit by bit as extrinsic value whittles away. This is due primarily to the fact that the short call option possesses more extrinsic value than the long call option making the spread positive theta. When choosing to use call spreads, one must be aware that they perform more like position trades and take time to mature. For the impatient not wanting or willing to wait too long, you may consider using shorter term options. Though this doesn’t provide as much time for the stock to move above the higher strike of the spread, it does produce quicker results if you are indeed right.

As far as early assignment goes, you would not have been assigned this early in the game and even if you were it’s to your benefit, not detriment. Keep in mind when an option owner exercises, they lose any remaining extrinsic value in the option. Thus, if there was still $4 or $5 of extrinsic value in the 250 call option, they would be better off selling it as opposed to exercising. For illustrative purposes, let’s say you were assigned and obligated to sell 100 shares of stock at $250. Again, this isn’t necessarily a bad thing. You still own the 240 call and thus have the right to buy 100 shares at $240. If you exercised that right, bought 100 shares at $240 and sold them at $250, you would net $10. Since you entered the trade at $4.80, you would essentially be capturing your $5.20 of profit. And the beauty of it is you realized it in March instead of having to wait until July.

So did you make any mistakes? The answer really depends on what you were trying to achieve. If you were satisfied with the profit and had planned on exiting after a decent sized gain, then I’d say you did ok. On the other hand, if you were shaken out early because of fears of early assignment, I’d say perhaps you did make a mistake. As outlined, those fears are unfounded.

For related posts, readers can check out:
Call vs. Put Spreads
All that Glitters is GLD

Adjustment Thinking and the Salvation Syndrome

2010-03-23T09:17:00.000-07:00

One of more prevalent ways many novice traders cut their teeth learning options is purchasing call and put options. While buying a directional call or put can provide large profits when right, they can be downright painful when wrong. It's rare to find traders who can rake in consistent profits when buying options is the only weapon in their arsenal. One would certainly have to be adept at forecasting a stock's price direction; a feat much easier said than done. When attempting the occasional long option trade, I've found increased success when using various adjustment techniques. Adjustment thinking in general helps with adapting to changing market conditions. The two primary objectives of adjusting are locking in gains and reducing or shifting risk.

When entering the realm of adjustment thinking one must be careful to avoid what I call salvation syndrome. This insidious disease can potentially rack up trading costs and compound losses. It's primarily characterized by traders who are constantly adjusting losing trades in an attempt to salvage some type of gain. They've got a bad case of the fix-its and rather than just exiting when trades go awry and moving to greener pastures, they attempt continual adjustments which often compound their problems. Consider the following example:

Suppose you sell an April 55-50 put spread on a $60 stock you deem bullish and expect to rise over the coming month. After 2 weeks of lackluster price action, the stock falls to $55 threatening to breach the higher strike of your put spread. Not wanting to lock in a loss, you decide to roll the put spread down and out to a May 50-45 put spread in an effort to make money back if the stock stabilizes or rallies. After making this adjustment, the Trading Gods unfortunately decide you need a better appreciation of Murphy's Law and therefore proceed to take the stock lower. As the stock approaches $50, you once again decide to "salvage" the trade by rolling to a June 45-40 put spread. Sensing that you're failing to learn the lessons, the infamous Trading Gods once again knock the stock down. Rinse and repeat...

In this example your adjustments merely served as salt to the wound, insult to injury, a compounding of your losses. Sometimes the best course of action is to simply exit. Let's be clear- there is nothing wrong with adjustments when used properly; there is something wrong when used improperly. I'll review a few such proper examples in subsequent posts.

Bummer

2010-03-22T06:33:00.000-07:00

VIX Expiration Thoughts

2010-03-17T11:45:00.000-07:00

March VIX options expired today with a settlement price of 16.68. Though the fear index gave a valiant effort in trying to remain elevated long enough for the naked put play mentioned in last week's Fading Complacency post to come out profitable, the incredibly low realized vol of the market won out in the end. With both 10 and 21 day historical volatility sub 10% on the SPX index and continuing to decline, it was simply a matter of time before the VIX caved in and became more in line with the day to day movements of the market.

[Source: CBOE]

We mentioned shorting the March 18 put for $.50. This placed the expiration break even for the trade at $17.50. With the settlement price coming in at $16.68, the trade would have lost $.82 had you held to expiration. If you exited early you could have easily locked in some type of profit or at least broke even. At one point over the last week the puts were trading at $.20. Within my own account, I ended up just buying them back yesterday at $.50 to break even.

This month's settlement illustrates why I don't usually hold these naked put plays into expiration. With the overnight gaps that can occur in the SPX and settlement being calculated off of the opening prices, you never really know what you're going to get. Tack on the fact that the naked puts weren't even profitable the day before expiration and you really don't have much of a reason to take the gamble of holding.

Stock Replacement Redux

2010-03-15T09:17:00.000-07:00

During Friday night's Options Action, a review of GS brought up discussion of stock replacement strategies. As traders we're constantly faced with the decision of when to take profits. Suppose we purchased 100 shares of GS last month when it was around $150. Over the past few weeks, GS has experienced a nice 15% rise in its stock price to $175. One dilemma facing us at present is whether or not we should take some money off the table. From a purely emotional standpoint, greed is tempting us to stay the course in the hope of garnering additional profits while fear is tempting us to jump ship to avoid giving back any gains. One potential method of compromise would be to enter a stock replacement strategy. The underlying rationale for entering the replacement is lowering your downside risk, while maintaining exposure to further gains if GS continues to rise.

The suggestion was to replace the long stock position with an April 180-190 vertical call spread (often referred to as a bull call spread or buying a call spread). Consider the risk graph:

[Source: MachTrader]

By purchasing the call spread for $280, we've drastically reduced the risk as well as capital tied up in the trade. In addition, we've also succeeded in maintaining upside exposure if GS continues to rise over the next month. In replacing the long stock trade with this call spread, the trader must obviously be willing to limit any additional upside to $720. Considering owning 100 shares of GS at $150 ties up $15K, dropping the capital requirement to $280 is worth limiting the profit potential in my opinion.

Stock replacement strategies highlight many of the advantages of using options to supplement a stock trader's game plan.

For related posts, check out:
The Replacements- As Good as the Original?
Options Action Posts

What Will They Think of Next?

2010-03-12T07:48:00.000-08:00

When it comes to trading platforms, I get as giddy as the next guy when exploring new innovative features. My curiosity perks up every time I receive word of a new release looming on the horizon for the platforms I use in my own trading. Though there are no doubt numerous ways to slice and dice data, I appreciate the few times the programming gurus behind the scenes come up with a more efficient way to display pertinent information. I was therefore pleasantly surprised when Livevol Pro's newest build included a whiz bang 3D tool on volatility skew.

[Source: Livevol Pro]

As long time option traders know, each option strike trades at its own implied volatility. The beauty of the 3D vol skew chart is the ability it gives users to compare volatility across different strikes and expiration months. This aids in selecting which options to use when structuring various strategies. Because the skew charts are in 3D, users have the ability to view them from different vantage points to get a better idea of their depth. Wanting to go for the gold, they also added the ability to view a playback of how vol skew has evolved over time. Watching the progression of volatility helps in identifying and better understanding the typical volatility build that occurs prior to important events such as earnings or FDA announcements, as well as the severe volatility crush that occurs following the catalyst.

For related posts, readers can check out:
Volatility Skew and Ratio Spreads
Gaming the Sell off with Put Ratio Spreads
Finding Volatility
The Cycle of Implied Volatility

Fading Complacency

2010-03-08T20:42:00.000-08:00

With the recent upsurge in equities, volatility as measured by the VIX (formally called the CBOE Volatility Index), has gotten utterly clobbered. With 21 day historical volatility of the SPX sitting at a measly 11%, it could certainly be argued that the heavy VIX is justified. After all, nobody like's buying options at 20% volatility on a stock that's only realizing 10%. In hindsight it's easy to see that the early Feb VIX super spike to 29 was overdone. Boy has that inflated volatility bubble fizzled fast. The important question at hand is whether or not the pendulum has swung too far in the other direction? Has excess fear turned into too much complacency? Well, it's fair to say the VIX is oversold by just about any measure (proximity to moving averages, overstretched date & range, etc...).

As is customary with this time in the expiration cycle where expiration be comin' round the mountain, let's see if there are any plays worth considering. While the cash VIX closed the day at 17.79, March VIX futures are a tad higher at 18.35. Remember, March VIX options are priced based off March Futures, not the cash. As such, the 18 strike put option is out-of-the money, not in-the-money. If we wanted to fade the complacency we may consider selling the 18 strike put for $.50. While it would be nice to receive more premium, with a mere 7 trading days remaining before expiration (VIX options last trading day is next Tuesday), it's tough to find much premium remaining.

[Source: MachTrader]

On the other hand, if you thought the VIX likely to continue its drop into the abyss, you may consider keeping it simple and buying an in-the-money put such as the March 19 or 20 strike.

For related posts, check out:
The VIX and Top Picking
VIX Options Laid to Rest While the Cash Springs to Life
Quick VIX Question

Take That Vol Sellers!

2010-03-04T07:27:00.000-08:00

How bout that MDVN... Wowza! If that doesn't give volatility sellers the heebie jeebies I don't know what will. That type of monster gap is the exact reason why selling naked strangles in front of a huge event is often considered crazy talk. It also supports the notion that options can indeed be a buy at 250% + volatility levels. I suppose it's a good thing I'm not a betting man because my volatility fade mentioned in the last post would have gotten absolutely smoked.

Ahhhh... the safety of the sidelines.

Let this serve as a lesson to any of you newcomers to the options arena that volatility gets bid up in biotech stocks for a very good reason (click to enlarge).

[Source: Livevol Pro]

Crazy Biotech Bid Ups

2010-03-02T14:26:00.000-08:00

One of the more common methods of volatility analysis used by option traders is that of comparing historical volatility to implied volatility. The efficacy of this approach hinges on whether or not the past can be a good predictor of the future. In other words, can a stock's price behavior over the last 30 days be a good indicator of its behavior over the next 30 days? If you think it may, you're probably a proponent of this form of analysis. The biggest fly in the ointment however, is the fact that there are often events looming on the horizon, such as earnings or FDA announcements, that will drastically influence a stock's volatility. While these have no influence whatsoever on historical volatility, they will surely cause some noise with implied volatility.

In anticipation of these known events implied volatility will almost always be trading at elevated levels compared to historical volatility. This does not automatically make options a slam dunk sell. Take the current case of Medivation (MDVN). Though its 20 day historical volatility sits at a mere 40%, implied volatility has risen to an astronomical 260% (click to enlarge).

[Source: Livevol Pro]

Though the casual observer may suspect the options are a raging sell, there's more to this outrageous bid-up than meets the eye. As with most biotechs, MDVN has a blockbuster drug currently being tested which represents a potential windfall profit generator if approved. Due to the huge ramifications of this study, its results could cause the stock to swiftly double or halve. Just as with most binary events, options get bid up to extremely pricey levels beforehand.

We're I betting man I'd probably fade the volatility spike with a limited risk short vol strategy like a condor. Though there's enough juice in the OTM puts all the way down to the 15 strike, the upside calls top out at 75.

With setups like these I prefer to park myself in the safest spot in the lot... the sidelines.

For related posts, check out:
The Tempest and Volatility Analysis
The Cycle of Implied Volatility

Alternative UpTick Rule

2010-02-28T07:59:00.000-08:00

Washington, D.C., Feb. 24, 2010 — The Securities and Exchange Commission today adopted a new rule to place certain restrictions on short selling when a stock is experiencing significant downward price pressure. The measure is intended to promote market stability and preserve investor confidence.

This alternative uptick rule is designed to restrict short selling from further driving down the price of a stock that has dropped more than 10 percent in one day. It will enable long sellers to stand in the front of the line and sell their shares before any short sellers once the circuit breaker is triggered.

"The rule is designed to preserve investor confidence and promote market efficiency, recognizing short selling can potentially have both a beneficial and a harmful impact on the market," said SEC Chairman Mary L. Schapiro. "It is important for the Commission and the markets to have in place a measure that creates certainty about how trading restrictions will operate during periods of stress and volatility."

Short selling involves the selling of a security that an investor does not own or has borrowed. When shorting a stock, the investor expects that he or she can buy back the stock at a later date for a lower price than it was sold for. Rather than buying low and selling high, the investor is hoping to sell high and then buy low. Short selling can serve useful market purposes, including providing market liquidity and pricing efficiency. However, it also may be used improperly to drive down the price of a security or to accelerate a declining market in a security.

The alternative uptick rule (Rule 201) approved today imposes restrictions on short selling only when a stock has triggered a circuit breaker by experiencing a price decline of at least 10 percent in one day. At that point, short selling would be permitted if the price of the security is above the current national best bid.

Rule 201 includes the following features:

Short Sale-Related Circuit Breaker: The circuit breaker would be triggered for a security any day in which the price declines by 10 percent or more from the prior day's closing price.
Duration of Price Test Restriction: Once the circuit breaker has been triggered, the alternative uptick rule would apply to short sale orders in that security for the remainder of the day as well as the following day.
Securities Covered by Price Test Restriction: The rule generally applies to all equity securities that are listed on a national securities exchange, whether traded on an exchange or in the over-the-counter market.
Implementation: The rule requires trading centers to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent the execution or display of a prohibited short sale.

* * *

The rule will become effective 60 days after the date of publication of the release in the Federal Register, and then market participants will have six months to comply with the requirements.

Here's a link: http://www.sec.gov/news/press/2010/2010-26.htm

Graphing an Option's Evolution

2010-02-25T10:25:00.000-08:00

One question I have about risk graphs is why each of the multicolored lines representing different time frames is different?

Thanks for the question Greg. The short answer is time decay. Remember, options are decaying assets and erode in value over time. In addition, the rate of time decay increases exponentially as expiration approaches. Even if all other variables remain constant (ceteris paribus in economic speak) throughout the trade, time decay will incrementally whittle away an option's value. Risk graphs attempt to portray the effect of time decay by showing two different lines: the current and expiration graph. In addition to the two default risk graphs, many software platforms offer the ability to add additional graphs giving you a snapshot of how the trade is expected to evolve between now and expiration. The iron condor risk graph displayed below depicts the profit/loss at various points in time.

[Source: MachTrader]

By viewing the relationship between the different colored lines we can infer if time decay is a benefit to the trade or a detriment. If the lines are rising as time passes (blue to red to green to black), then time is an ally. In greek speak we'd say the position in positive theta. Conversely, if the lines are falling as time passes, then time is an enemy and your position is negative theta.

For related posts, check out:
Theta
Greeks

Utility of a Risk Graph

2010-02-23T10:46:00.000-08:00

Yesterday's post asserted that most experienced option traders have a dualistic approach when selecting strategies. That is to say they assess both their outlook on the stock as well as their outlook on volatility. The ideal outcome for all option trades occurs when both volatility and the stock move in the right direction.

Part of the learning curve with options is familiarizing yourself with the effect of volatility on individual option strategies. Performing "what-if" scenarios and stress testing your option positions is very easily done using risk graphs.

A risk graph is an analytical tool which gives a visual display of the risk-reward characteristics of option positions. Most risk graphs offer the ability to adjust various inputs such as time to expiration and volatility so that traders can model the effect these changes will have on their position. In addition to helping traders understand the influence of time and volatility, risk graphs can also aid in position sizing. Since they give us the ability to calculate how much a position will lose if things move adversely, we can determine how much is at risk in each trade. This in turn aids in determining how many contracts to enter in the position (click image to enlarge).

[Source: MachTrader]

Nowadays most online brokers tailoring toward option traders offer some type of risk graph within their tools. In addition to these brokerage firms, there are also other trading platforms offering option analytical tools. Regardless of what source you use, risk graphs certainly deserve a spot in every option traders toolbox.

An Option Trader's Thought Process

2010-02-21T21:29:00.000-08:00

I received a question the other day in regards to using options to bet on changes in volatility. Though most seasoned readers are familiar with the many facets of option trading, let's take another look at how options are used by various market participants. Options are typically used to bet on direction, volatility, or a hybrid of the two. I suppose we could create another category for option plays seeking to exploit neither direction nor volatility, but time decay. We'll let that specific subject simmer in the idea vault for a while longer and focus today on the first two.

When contemplating an options trade, most traders first seek to determine whether or not they have a directional bias in the underlying stock. After determining their directional bias (bull, bear, neutral), many novice investors immediately proceed in selecting which strategy they want to use. If bullish they may opt to buy a call option. If bearish, they may simply buy a put option. While placing a trade based on your directional bias is important, due to the huge impact volatility has on an options price, it is also crucial to determine whether or not you have a bias on volatility. Does volatility seem too high or too low? Upon becoming more familiar with volatility, most veteran option traders use a dual approach of considering both their directional and volatility bias. For example, if one was bullish on the underlying stock and bullish on implied volatility, they would probably opt for a different strategy than if they were bearish on implied volatility, such as buying a call option versus selling a put option.

There are yet other scenarios where a trader may hold a bias on volatility, while lacking any significant bias on a stock's direction. Before jumping into a trade, first decide which variable you're trying to exploit: a stock's price direction, volatility, or both. Then select an option strategy that is poised to profit in the anticipated market environment.

The Crossroads

2010-02-17T08:15:00.000-08:00

The SPX has managed to claw its way all the way back up to 1100 which is a crossroads of sorts. In addition to being a prior resistance level, we also having the 50 day moving average looming closely overhead. This mornings test of 1100 on the ES failed, so the bears have won the initial attempt to break above this key level. It will be interesting to see how the price action unfolds and whether or not the bulls can muster the strength to push back above the 50 day moving average thereby placing the SPX back into an uptrend. This would no doubt come as a disappointment to the bears and cause me to temper my enthusiasm for entering any additional bearish trades (click image to enlarge).

[Source: EduTrader]

Assuming we remain below this level, this week's retracement has certainly setup a more favorable risk-reward for those looking to enter bearish plays.