The New World Of Volatility Spreads (VIX, VXN, RVX)

Brainteaser

by Jud Pyle


Vol Spreads
As you’ve probably noticed, implied volatility levels have shot markedly higher during the past few months. The financial crisis unofficially kicked off on September 15th, the day Lehman Brothers announced its bankruptcy plans. That fateful Monday, the CBOE Market Volatility Index (VIX) closed above 30, and hasn’t turned back.

VXN / VIX Spread
Traditionally, the CBOE Nasdaq Volatility index (VXN), which measures 30-day implied volatility levels on the tech-rich Nasdaq-100 Index (NDX), produces higher reading than the VIX, which tracks volatility for the S&P 500 Index (SPX).

For years, the VXN ran about three or six volatility points higher than its counterpart. But in December, the VIX closed at 63.64% while the VXN was at 62.59%. The VXN was eclipsed! In fact, from October through December, the VIX was consistently higher than the VXN. Uncertainty in financial names has powered these volatility levels higher and kept them elevated – not concern about tech names.

RVX / VIX Spread
Meanwhile, the CBOE Russell 2000 Volatility Index (RVX), focused on the volatility readings of small-cap names, tells another interesting tale. Typically, the spread between the RVX and the VIX has been about three to five points, with the RVX higher.

During the initial spike in the VIX, the spread was narrowed to about one point. But, with recessionary pressures hitting all economic sectors, small-cap names are being impacted as well. The spread widened again in December, with the RVX closing 9.7% higher than the VIX.

Investors could be looking at the increased strain on the credit markets, and smaller businesses’ need to access credit. The longer lending practices remain tight, the more difficult it might be for small-cap names to stay afloat.

Brainteaser

Getting To Know Options Volatility
Getting To Know Options Volatility
I've probably mentioned the term volatility in every article I'vewritten about options trading. Everyone probably has an intuitive feelas to what volatility means, for example looking at the followingcharts of stocks ABC and XYZ, it's pretty clear which one is morevolatile. If you think it's XYZ, you probably should hold off a littlebefore you start trading options (or anything else for that matter.)



So how do we define volatility and how do we measure it? In generalterms, volatility is the rate that the price of a security moves up ordown. It is measured by the annual standard deviation of the dailyprice changes in the security. Digging down a little deeper, thestandard deviation is calculated by taking the square root of theaverage of the squared differences between the daily percentage ratesof return and the average of the daily percentage rates of return.

That's a mouthful and it doesn't even tell the whole story! Instead ofusing percentage rates of return in the calculation, in reality, thelogarithm of the percentage rates of return is used. Without turningthis into a math lecture, suffice it to say that using logarithms inthe calculations prevents the possibility of predicting negativesecurity prices.

The good news is that while it's important to know what volatilityrepresents, we'll never have to actually calculate it. Of course, ifyou are mathematically inclined, it wouldn't hurt to try and do thecalculations at least once to be sure you really understand how theywork. There are 3 kinds of volatility that we have to differentiate:historical (also referred to as statistical), implied, and futurepredicted. Each one is important to know and use in our trading.

Historical Volatility
As the name implies, historical volatility represents volatility thathas occurred in the past. It can be measured over any period of time,but to make it comparable, it must be annualized.

Standard measurement periods are 20, 50, 100 and 200 days and weekly,monthly, and quarterly are also quite common. When studying volatility,it's important to know what the time period for making the calculationis. Note, that this volatility is related to the underlying security,it's not related to the options.

Implied Volatility
If you think back to the Black Scholes formula for calculating thetheoretical value of a Put or Call option, you'll remember that we needto know the value of 6 variables to plug into the formula. Well 5 ofthem are easy to determine: the price of the stock, the exercise price,the time left until expiration, the risk free rate of return, and theannual dividend rate.

The 6th one, volatility, isn't so easy to predict. However, since weknow what price the Put or Call is actually trading at, we can plug the5 variables into the formula and determine what value of volatilitywill produce the option price that we already know. In other words, wework the formula backwards and determine what volatility we need toinput into the formula to produce the correct option price. This isreferred to as implied volatility. In essence, it is the market'sprediction of what the volatility of the stock will be from today untilthe expiration date of the option.

This concept is very important and if you hear professional traderstalking about buying and selling options, they might be talking aboutlevels of implied volatility instead of dollar prices. For example, youmay hear "I sold the June 45 Calls at a 45 implied volatility andbought the August 45 Calls at a 39 implied volatility."

Future Predicted Volatility
In a perfect world, we would be able to look at our crystal ball andknow what the volatility of the stock will be from today untilexpiration. Given that information, we can plug all six variables intothe Black Scholes formula and determine with a large degree ofconfidence what the value of the option should be.

So if we calculate the value of a Call to be $3.00, and it's trading at$2.50, we would be comfortable buying this Call and setting up a deltaneutral hedge. The idea would be to capture the difference between thetheoretical and actual value of the Call. Alternatively, if the sameCall is trading at $3.50, I would most likely want to be a seller ofthat option.

The VIX
In addition to individual stocks having volatility, indexes havevolatility as well. The most well known index volatility is the VIX,which is supposed to represent the volatility of the stock market ingeneral. It is often referred to as the fear index. When there's a lotgoing on in the market and stocks are moving quickly (like now) the VIXis high, when there's less economic turmoil, VIX decreases.

This concept of a market volatility was first introduced by the ChicagoBoard Options Exchange in 1993, although they did calculate it back to1986 to show how it would react under different market conditions. Ithink they wanted to capture the experience of the 1987 crash.

The VIX was originally based on the S&P 100 index as therepresentative of the market. It was supposed to represent the impliedvolatility of a 30 day at the money option. Since it was usually not 30days to expiration, a methodology involving interpolation between 2months and several different strike prices was used.

In 2003, several significant changes were made to the VIX. The mostimportant of which was changing the representative market to theS&P 500 from the 100. Several other changes in methodology werealso introduced, but the VIX still represents a 30 day at the moneyimplied volatility. Since the original VIX calculation was being widelyused, the CBOE has continued to publish the old style index with a newticker symbol of VXO.

Due to the immense popularity of the VIX, the CBOE has started toprovide implied volatility data on several other indexes: VXN is basedon the Nasdaq 100, RVX is based on the Russell 2000, and VXD is basedon the Dow Jones Industrial Average.

It is anticipated that many more indexes will have their impliedvolatilities disseminated on a regular basis and that other measures ofimplied volatility (say for periods other than 30 days) will alsobecome popular. As if this isn't enough, there are now futures on theVIX and options on the VIX futures. Who knows what products and tradingvehicles will be introduced in the future.

Hopefully, you have a better idea of what volatility means and how itis calculated. In later articles, I'll cover the subject of volatilityskew, and how we can use that skew to make money in our trades.

As always, if you have any questions about my articles, havesuggestions for future topics, or want more information about ouroptions mentoring program, feel free to email me at: SFreifeld@tradingacademy.com or call me at: (888) OTA-2580 ext. 2010.

Brainteaser

VIX Questions
VIX Questions
I've had two great questions about the VIX from our viewers recently. Here they are:

• Question #1: What did you mean by the "rule of 16" regarding volatility and how does that explain the VIX vaulting to 80?

Rule Of 16
Volatility is almost always expressed as the annualized standarddeviation of returns. But an important characteristic of volatility isthat it is proportional to the square root of time. That means we canapproximate volatility over a smaller time period than one year bydividing the annual volatility by the square root of the number oftrading periods we are interested in.

So if we want to convert annual volatility to daily volatility, we candivide by 16, which is the square root of 256 -- about the number oftrading days in the year.

Back in the days when volatility was 15-20% annually (way back in2007?), daily volatility was about 1%. So we whipped out the "rule of16" to answer the question, "Is the VIX overstating volatility?"

Well, when you divide a recent VIX reading of 80 by 16 you get 5%. Andas we noted, 5% daily volatility isn't too far off the mark with thekind of moves the stock market has been having!

• Question #2: What does it mean when you saythat "their vegas are so low that a very small increase in the option'sprice can have a big impact on their implied volatilities?"

We were addressing the phenomenon of deep out-of-the-money (OTM) putshaving a disproportionate effect on the VIX. As we explained in ourinterview, "Way OTM options are insensitive to volatility changes in anabsolute sense, but not on a percentage basis."

Since vega is the change in an option's theoretical value for a 1% movein volatility, you can derive an implied volatility change from achange in option premium and a vega to see how this works.

Assume a vega of .0005 (which is typical for the 300-strike puts withthe SPX at 850). Now divide that into a one-cent option premium moveand you get a volatility move of 20.

Here's another example: An at-the-money (ATM) option might have a vegaof .05 and an OTM a vega of .005. So a $.05 change in the premium ofthe ATM is one volatility point, but the same change for the OTM optionis 10 vol points.

Brainteaser

Is The VIX For Real?
by Kevin Cook

Is The VIX For Real?
There's been lots of talk about the CBOE Volatility Index (VIX)recently, and not just because it's stuck in the stratosphere. Sometraders have raised controversy about whether it is an accuratereflection of volatility in the market place, especially after theOctober VIX futures expiration.

They were upset about the disconnect between the VIX futures, whichclosed around 53, and the VIX calculation itself the next day. Thefutures were subject to a final settlement with that calculation and itcame in at around 64. "Ouch!" if you were short. But, it's highlylikely that those traders don't understand the VIX.

Many traders believe the VIX is calculated by using the "implied"volatility of at-the-money S&P 500 Index (SPX) options, and thismay be part of their confusion that becomes the source of their angstthis week.

If you understand how the VIX is calculated, and how it moves in acontinuous feedback loop with real market action, then you will not beso fooled as they are. Granted these are wild, unprecedented times formarkets and volatility, and anybody could be fooled. I just thought I'dsee what I could do to help lessen some of the confusion. Hopefully Idon't make it worse.


VIX Basics
A little review of the basics might be in order here for newer option trader/investors:

1) SPX is the the symbol for the S&P 500 Stock Index.

2) Options on the SPX are traded on the Chicago Board Options Exchange (CBOE).

3) At-the-money options are those with strikes closest to theunderlying price, e.g., with the SPX at 903, the ATM options are the900 and 905 strikes. In-the-money (ITM) describes options withintrinsic or real value like the 875 calls or the 925 puts (you couldexercise them into actual units of the underlying and profittheoretically). Out-of-the-money (OTM) means no intrinsic value (925calls and 875 puts in this example).

4) Implied volatility is the volatility that options are actuallytrading at. It's not what the market did in the past, which is what wecall historical volatility. To calculate implied volatility, traderssimply take their option pricing model and instead of entering in thevolatility (historical or forecast) input to get an option price, theyput in an option price and solve for volatility. This is how optionprices "imply" a current volatility.

Expected VS. Actual
Traders are questioning the VIX calculation because they assume whenthe VIX goes "off the charts," it is not a real reflection of themarket's "true" volatility. Well, that's sort of true. But the VIXcalculations (old or new) were never intended to reflect actualvolatility. They were designed to reflect "expectations" of volatilityimplied by options prices. So traders who are mad at the VIX probablythink, "If it's just what prices people were paying foroptions--typically, what they are over-paying for puts in a marketmeltdown like we're having this month--then maybe it's not fair." Okay,but then what are you going to use to gage expectations about futurevolatility?

Maybe they want the VIX futures to trade like and settle to the actual,"realized" volatility, which is known only after the day, week, ormonth has ended (whatever time period you focus on). This realizedvolatility will be much lower than the VIX, they probably believe, andso the VIX is bound to come down.

But that's apples and oranges. The VIX is about market expectations ofthe future which can change on a dime. Actual historic, or realized,volatility is in the past and can't be changed. Maybe someone will makean index based just on historic volatility some day, but then againthat's what options are all about. If you are right about realizedvolatility, you will be rewarded as your long options gain value bymoving ITM and your short options decay because they stay OTM.

The VIX is designed to give investors a forward view of volatilityexpectations, not a rear view of what has already happened. So theproducts that trade off of it, like VIX futures and options, are riskmanagement tools that allow investors to hedge their exposure tovolatility. We don't have risk in the past, right? Options alwaysprovide a future view of volatility. They may not always be right, butthat's what makes a market--buyers and sellers gauging uncertainty.

Traders who believe the VIX uses implied volatility are misled. Why?Because the VIX is calculated using just option prices. It doesn't"back out" or solve for implied volatility using an option pricingmodel like Black-Scholes. The "new and improved" VIX (it was revamped afew years ago) takes option prices of out-of-the-money (OTM) puts andcalls and averages their "weighted" prices with a little math based onput-call parity and time to expiration.

This was a calculation that many finance professionals and investorsfelt was a more balanced and accurate way of measuring volatilitybecause it took into account a broader spectrum of option strikes thatdefined perceived risk (i.e., expected volatility) better. For moreinformation about the VIX structure, logic, and calculation be sure tovisit the CBOE.com website. Tons of info there. Read as much of it asyou can. I am still reading it to understand this most-importantvehicle for investors and traders.

Option Arbitrage
Okay, so how are some traders further misled in assuming that optionprices don't reflect actual volatility? By missing the fact of thesophisticated and very liquid arbitrage that occurs between equitymarkets and their options. If someone is buying SPX 300 puts thismorning--yes, someone has bought puts today on the market for thepossibility of a drop of over 65% from here!--this is real informationin the marketplace that ends up getting priced into the actual orrealized volatility, almost in real time.

Now, some conspiracy theorists think that hedge funds and other largeplayers could manipulate the VIX calculation simply by trading thosedeeply OTM puts and thus raising the volatility abnormally. In fact,even putting a bid in some of these markets could affect the VIX. Whywould they do this? Because they have other exposures to volatilitybesides stocks and options. They trade something called variance swaps.That's something we can't be sure of, but surely will be the subject ofsome discussions in the coming weeks.

As of this writing, puts from the 550 strike all the way down to the300 strike in NOV SPX options have combined open interest of over225,000. Some of that is likely spreads, where traders may have bought800, 700, and 600 strike puts and partially paid for them by selling 2or 3 times as many deep OTM puts below the 500 strike. Nobody in theirright mind can possibly think that the S&P 500 is going downanother 65% (from 850 to 300) by November! But, they might be able tomake money on a volatility spread where they buy the 500 puts and sell2 or 3 times as many 300 puts.

And speaking of whether actual volatility is anything like the VIXwe've seen this month, it actually is. 30-day historical volatility isin the 60 to 70 range. Seems like the forward view of volatility foundin the VIX is tracking actual volatility quite well.


Mega Puts Traded on SOQ Settlement Day is Suspicious
It looks like the majority of those deep out-of-the-money (OTM) SPX(NSDQ: SPX) put options were traded in advance ofthe Special Opening Quotation (SOQ) procedure used to setlle VIX(INDEX: $VIX) products.

That "possible manipulation" is beginning tolook probable. At least according to the data that I haveseen. During the two sessions after the SOQ, I simply noticed the continued tradingand rise in open interest into the 200,000+ arena in just the 550through 300 strikes alone.

Why 300 Strike Puts Matter in the VIX
Here's why those 300 puts can affect the VIX: the calculation goes downthe list of strikes including every strike with a bid. That's right, itdoesn't even have to trade. The calculation accepts every bid/ask anduses its midpoint, until it finds two consecutive strikes without bids.The "carpet bomber" made sure all puts were in that day's party.

Thevolatilities implied by the bids and trades on these deep OTMputs--with only a month to expiry!--are in the triple digits, and sincethey are averaged into the VIX calculation, they drive it higher.That's why I initially questioned the logic and motives of anyoneputting a bid in the 300, 400, or even 500 puts.

They knew they wouldget hit and were probably up to something big to take on that kind ofrisk. Let's take just 1/3 of Bill Luby's $150 million figure. Someonewith $50-100 million in volatility exposure, whether in VIX options,VIX futures, or OTC variance swaps, could easily have taken $25-50million in risk in SPX options to "game" the VIX settlement.

The Institutional and Market Maker Hedging Feedback Loop
Beyond that, this weekend I read a research report from JP Morgan aboutvariance swaps and the SPX/VIX feedback loop. Variance swaps arecomplex OTC (over-the-counter, non-regulated, private, customized)contracts between banks and hedge funds, for instance, that allow oneto either buy or sell realized volatility.

The JPM report, "MarketImpact of Derivatives Hedging" in fact confirmed my ideas that theinstitutional and market maker hedging feedback loop between equities,index options, futures, VIX products, and OTC variance swaps--which aresettled daily to actual or "realized" volatility--can indeed driverealized vol higher.

Bottom-Line for Traders: Know Your Instrument and Your Risk
An investigation is probably in the works and hopefully not too manysmall players got hurt. With the unprecedented banking system andmarket meltdowns--and the giant price swings they engender--these VIXvehicles are toys for big players only. As always, independent tradershave to know and understand the instruments they are trading, as wellas the risk of the positions they take in them.

Be sure to catch my interview with ONN.tv's resident quant, JoeTroccolo, about the VIX. Joe trained options traders at the infamousO'Connor firm two decades ago, and then went on to lead financialmarkets education at UBS Investment Bank.

Brainteaser

A Historical Perspective On Volatility & The VIX
A Historical Perspective
"Everyone seems to think that this level of VIX is the highestever. That’s not the case. When I created the VIX for the CBOE in 1993,I backdated everything until the beginning of 1986.

The highest level was 172.79% in the market crash of October 1987.October 1997 and October 1998 also experienced levels nearing 60+%.Maybe the current situation is simply an “October effect.” Granted theoriginal VIX based on the at-the-money OEX options and the new versionbased on all at- and out-of-the-money SPX options are slightlydifferent, their levels and movements remain close."

- Robert E. Whaley  Valere Blair Potter Professor of Management, The Owen Graduate School of Management, Vanderbilt University

CHART: DOW JONES VS. CBOE VIX

Brainteaser

Is a VIX ETF a Good Idea?
by Condor Options

A VIX ETF?
Bradley Kay at Morningstar would like to see an ETF that tracks the VIX:

• "Equities not only provide a return, but they alsohave a volatility that estimates how risky they look in the nearfuture. [...] While it has historically hovered around 20, the VIXfalls during quiet market periods and spikes when a flurry of tradingactivity buffets the stock market. An investment in this index wouldprovide a valuable hedge against periods of heightened uncertainty, andsince volatility has traditionally been higher in bear markets, itwould also somewhat hedge losses in equities. Individual investorscurrently have a hard time speculating on the VIX, as futures in theindex require minimum investments well over $10,000, but an ETF couldopen this valuable diversifier to the masses.

On first glance, this seems like a fantastic idea.  But we can think of three potential problems:

Devil in the Details
The implementation of this product would seem to be a real challenge. We’re not sure how such a product would work, even conceptually.  Itwould have to track the VIX on a tick-by-tick basis.

Mimicking the daily performance approach of the inverse ETFs (SDS, QID,etc.) wouldn’t work, or would at least make it a very differentproduct, since so much of the drama on any VIX chart comes from wildintraday action. And what about expenses?  The Proshares Ultra andUltrashort ETFs all have expense ratios of about 0.95%.  We wouldexpect a VIX ETF to cost at least that much, and possibly a lot more.


Why Bother?
Second, it’s not clear that a VIX ETF would provide anything special asa portfolio hedge, and it could even give false assurance to individualbuy-and-hold investors.  Volatility in general, and the VIX inparticular, do not have a precise inverse correlation to price movementin the underlying.  As we are eternally prodded into pointing out, VIXmovement is informative on a relative basis, not an absolute one.  


Kay says:

• "An investment in this indexwould provide a valuable hedge against periods of heighteneduncertainty, and since volatility has traditionally been higher in bearmarkets, it would also somewhat hedge losses in equities."

Obviously, any hedge (including cash) is better than none during a bearmarket.  But it’s not clear that this VIX product would do anythingspecial vs. the other inverse and balanced products already available.

The table below displays the performance of four $20,000 portfoliosstarted at the close of the recent market top on December 11, 2007. The first iteration buys SPY alone. The second buys a 5% hedge in thishypothetical VIX ETF, and puts the rest in SPY. The third buys a 10%VIX ETF hedge. The fourth buys BEP alone - an S&P 500 covered callfund.


The best performer during this period was hands-down the covered callfund.  And we’re giving the VIX ETF as much slack as we can:
   

• Obviously, the bigger thehedge during a bear market, the better performance will be; but thenyou give up more upside during bull markets - so we expect the relativeperformance of the VIX-hedged portfolios to be worse for any longerperiod.
• We’re also assuming thatinvestors can top-tick the market perfectly and put hedges in placejust in time.  That’s a rather generous assumption.
• We’reexcluding expenses over this period.  SPY has an expense ratio of0.08%; BEP, a closed-end fund, charges 1.06%; as we mentioned above, wehave to think that a VIX ETF would cost even more.
• Finally,we excluded dividends for all of these examples - including them wouldworsen the VIX hedge portfolios further on a relative basis.

One might object that savvy traders will trade around those famous VIXspikes, dumping their hedges for a nice profit when VIX moves above 28(or whatever the magic number du jour is). But it remains to be seenwhether a sufficiently liquid, accurately tracking ETF could even beconstructed.  And remember that a volatility ETF product would betargeted at less sophisticated individuals and institutions, who areless likely to trade around intraday movements.  

Active traders already have a universe of vehicles for accomplishingthe goals of this product - they are called “listed options.” Giventhat investor focus, we are skeptical about the usefulness of a VIX ETFfor hedging equity portfolios on a buy-and-hold basis.

Victim of Its Own Success
Finally, assume we’re completely wrong about everything we’ve saidabove.  Assume that this VIX ETF becomes the most celebrated product of2009, that it is liquid and accurate and has rock-bottom expenses. Pensioners and value investors all over the country start calling theirfinancial advisers to add VXY to their portfolios (in the tradition ofoverly cute names for ETFs - think Spyders, Diamonds, and Qubes -perhaps the VIX ETF will be “The Vixy,” ticker VXY).

Once everybody and his brother is in this product, there will be lessneed for the traditional hedges on the basis of which the VIX number iscalculated, namely, SPX options.  We have already seen this happen tosome degree as inverse ETFs and their options see increased volume.  

Maybe, in a more moderate scenario, the volatility ETF would become akind of slightly underperforming ghetto where retail traders andpensions and balanced funds would go, while the big boys stick withtheir traditional tools.  But if this product did start to pull seriousvolume from SPX put buyers, the VIX itself might become less accurateand useful, rendering the ETF less useful by extension.

We don’t mean to rain on any parades, but we wonder whether the onlypeople who would really benefit from such a product would be the ETFsponsors.

Brainteaser

How To Trade This Volatile Market
by Andrew Houghton & Nick Atkeson

Fear All Around
The credit freeze has left the market with a chill, and in some sense,investors are asking for vanilla while the market is serving Rocky Road.

Investors would love to go back to the days of the 1980s and 1990s whena buy-and-hold strategy would yield about 10% returns per year. Butsince 2001, it's become clear that the buy-and-hold market is no longerprofitable.

Take almost any of the S&P 500 (SPX) exchange-traded funds (ETFs)and look at their performance over the past eight years. Almost all ofthem show no appreciation -- and many have posted substantial losses.

The good news is that you can have your cake and eat it, too. Themarket has what we want, but we have to know where to look, given thestructurally elevated volatility levels.


Take Technology
Even in a world where we are all steadily using more technology in ourdaily lives, the Technology Select Sector Fund ETF (XLK) has gone fromabout $35 at the start of 2001 to about $16 today.

However, since 2001, there have been spectacular trading opportunities,including buying the index in July 2006 and selling in November 2007for a 50% gain.

We can safely say that the 17-year span from 1982 to 1999 was abuy-and-hold time. We also can safely say that from 2000 to some pointin the future that's still several years away, buy and hold will not bethe most effective strategy.

Studies of the past 80 years show that the market alternates betweentrading and trending cycles, with the market switching between thesetwo states about every 16 years.

And right now we are in a trading atmosphere that is predicted to last until 2015.

The Dark Side of Day Trading
At the opposite end of the spectrum from buy and hold is day trading.But how do you trade a market that can move 7% or more in eitherdirection within an hour?

The market's radical, intra-day moves have become virtuallyunpredictable, as opaque global financial factors drive the market inthe very short term.

The pros at hedge funds, who have the best information flows andfastest trading technologies, are generally getting hammered byattempting to keep pace with the daily market moves. As the marketbecame more volatile in September and October, average losses at hedgefunds for each month have exploded upward.

Long/short hedge funds lost more money in September than they hadyear-to-date through August. And losses in October make those inSeptember look small.

The Sweet Spot
So, if buy and hold is no longer the ticket, and day trading will likely lead to an aneurism, where does the answer lie?

Where it usually does -- somewhere in the middle.

Intermediate trends that last anywhere from a few weeks to severalmonths are predictable and profitable. They allow traders to capturethe bulk of the value from a longer-term trend while lessening overallmarket exposure and capital commitment.

The intermediate trend also allows traders to hang-on through the crazyday-to-day swings without being whip-sawed out of every hard-earneddollar.

It is our belief at Big Money Options that the intensity of thiscurrent crisis will subside and market volatility will "normalize" at anew, higher level. With more normalized patterns in place, our optionsindicators will once again regain their predictive force.

Options have been, and should soon be again, excellent predictors ofintermediate-term trends. On a stock-by-stock level, they track many ofthe most sophisticated, leveraged market participants. On a broadermarket level, they capture current market sentiment in real-time.

With the intermediate market trend identified, we take the extra stepof finding the most lucrative, low-risk options plays available.

By going long with a call option versus buying the underlying equity,we effectively have implemented a stop-loss trade. Capital is protectedin the event the underlying stock moves in the wrong direction by alarge amount (an everyday occurrence lately) and the upside is capturedin a leveraged trade.

Further, with put options, you can capture profit on the downside, thus you're protected in any market.

Keep Your Swing Under Control
One of life's great little pleasures is watching a golf ball fly longand straight after having hit it in the middle of the sweet spot with anice, easy swing. The same is true with options.

If you try to "kill it," you'll likely lose money. Invest a comfortable amount where if the trade goes badly, it's no sweat.

With too much money on the table, fear may make you lock in losses asthe volatility of the trade moves through its normal course.

Don't worry about missing the big one. When option trades go well, theyusually go very well, which can cover even several smaller losses.

The point is, you should buy when fear is at a high and sell when fearis at a low. As Warren Buffett says, be greedy when others are fearfuland fearful when others are greedy.

Although the negative news and credit crisis issues are not going awayimmediately, you should start to look at companies with top-notchmanagement, strong balance sheets and secular growth stories.

But remember, while the best view is always the one with a lot ofprofit on the horizon, the way to get there -- for now -- is to putbuy-and-hold strategies on hold. Take the middle road and let optionslead the way.

Brainteaser

Straddles: For When You're Just Not Sure

Spreads
Over the last few months I've discussed a lot of the basics of tradingoptions. It's like building a house; you start with the foundation. Asfar as actually trading, I've discussed Puts and Calls and a little bitabout Covered Calls. Now we're going to start thinking about differenttypes of spread strategies.

Why do we want to spread? Several reasons; it reduces the overall costand limits the risk of a position. At the same time it lowers thebreakeven point for the position and allows flexibility to takeadvantage of different types of market conditions. Of course, likeeverything else in trading, there is a trade-off. The maximum potentialon the upside may be capped, and there will be more commission costsand more bid/ask spreads to contend with.


The Straddle
Today we're going to examine some characteristics of a very popularoption trading strategy known as a Straddle. First we need to knowexactly what a Straddle is.

Definition: A long (short) Straddle is the purchase (sale) of a Put anda Call on the same underlying stock with the same strike price and timeto expiration.

Just as a point of information; some traders don't consider a Straddleto be a spread. They define a spread to be a position that consists ofboth long and short options. For our purposes, a spread will be anyposition that has both long and short deltas.

An example of a long Straddle would be the purchase of the XYZ July 50Call and the July 50 Put. If the Call is trading for $2, the Put for$1.75 and we bought 10 Straddles, the total cost (excludingcommissions) would be $3,750. Of course, if we sold the Straddles, wewould receive a credit of $3,750 coming into our account. LongStraddles must be paid for in full, they cannot be bought on margin andshort Straddles have margin requirements (that will be the subject of afuture article.).

The following graphs show the profit and loss for both a long and shortStraddle at expiration. Notice, that as you would expect, they aremirror images of each other. If one side makes money, the other sideloses the same amount.


CLICK HERE FOR THE FULL-SIZED CHART
Notes: The blacklines represent the Straddle positions. The purple and yellow linesrepresent the expiration graphs of the Call and Put, respectively.

Which Way To Move
Okay, so when do we reach into our bag of options strategies and pullout the Straddle? It's when we expect the stock to make a large move,but we're not sure in which direction the movement will take place.This can happen when an event is expected, such as earnings, a verdictin a court case, an FDA announcement, etc. There can also be unexpectedevents, such as a takeover, merger, announcement of a new product, orthe replacement of a key officer of the company, etc., that will causethe stock to make a large move.

Let's examine the characteristics of this spread in terms of the Greeksthat we spent so much time learning about. I'll talk about the longStraddle, but you know that the short side will be just the opposite.

DELTA and GAMMA– Assuming that the Straddle was put on with the stock price close tothe strike price, the delta will be close to 0, approximately +50 forthe Call and -50 for the Put. That means that the position doesn't havea bias to either the upside or the downside. However, since theposition is long the Call and the Put, and since both Calls and Putshave positive Gamma, the Straddle is very long Gamma. This means thatas the stock starts moving away from the strike, it will get shorter onthe downside and longer on the upside. That's exactly what we want!

We want the stock to move as far as possible from the strike price. Infact, we can see from the graph that the worst place that the stockcould be at expiration would be at $50. In that case the Straddle wouldbe worth 0, and we would lose the entire investment of $3,750. Inreality, we would have either exited the position prior to expirationor made adjustments along the way, and most probably would not havelost the entire amount. That process will be discussed in a futurearticle.

It's also always useful to know the breakeven points on the upside anddownside. Fortunately, in the case of a Straddle it's easy tocalculate. Simply add the premium to the strike price to get the upsidebreakeven of $50 + 3.75 = $53.75, and subtract the premium from thestrike price to get the downside breakeven of $50 – 3.75 = $ 46.25.

VEGA –Again, since the position is long options and long options havepositive vega, this position is very sensitive to changes involatility. So in addition to price movement, we are hoping for anincrease in volatility. Well, that implies that we would put thisposition on in a low volatility environment. Isn't that acontradiction? We want low volatility, but large movement in the stock!

Yes and no; at expiration the volatility doesn't matter anymore. Thestock price will be whatever it is, and that will determine the amountof profit or loss for the position. Prior to expiration, the volatilitycan have a great impact on the value of the Straddle. It is possiblethat with only a small movement in the stock, but with a significantincrease in implied volatility, that the Straddle could still beprofitable prior to expiration. Sometimes we can have our cake and eatit too!

THETA – Again, we're stilldealing with only long options, and long options have negative theta,so the position is losing value every day. Making matters worse, therate of loss is constantly accelerating. So what can we do to mitigatethis situation? We generally don't buy near term Straddles.

A rule of thumb is that Straddle buys should be 3 months or more toexpiration. I said "generally" for a reason. There are some situationswhere it does make sense to buy near term Straddles, and in fact, oneof my favorite types of trades has to do with buying Straddles on theday of, or day before, expiration. You'll have to keep reading thesearticles to learn about that one!

Why have I focused only on the long Straddle? Take another look at thegraph. Notice how it can have unlimited losses on both the upside andthe downside. It's unfortunate, because there are times when you mightwant to sell the Straddle but are afraid to assume the risk of a largeprice movement. Well fear not, there are ways to control the risk, butthat leads to another type of position (it's called a Butterfly) onanother day.

While you're digesting the above, I'm going to give you a bonus. It'ssomething that most traders, including professionals, don't know. Infact, it's something I normally only share with my mentoring students.It's a formula, and here it is:

ATM Straddle premium = .8 x S x V x SQRT(T)

Where,
S = Stock or strike price (they are the same since it's At-The-Money)
V = Volatility, and
T = Time to expiration in years

In the example above, S = $50, V =.23, and T = 60 days or .1644 years.Plugging into the formula yields: .8 x 50 x .23 x SQRT(.1644) = $3.73versus the actual premium of $3.75. Not too bad!

As always, if you have any questions about my articles, havesuggestions for future topics, or want more information about ouroptions mentoring program, feel free to email me at:sfreifeld@tradingacademy.com or call me at: (888) OTA-2580 ext. 2010.

Brainteaser

Sell Volatility to Outsmart This Market

The New Pres
President-elect Barack Obama, as our nation's 44th leader, is receivingthe keys to the car with the gas tank empty, the tires blown out, thetransmission broken and the battery dead.

Hoping he can turn this wrecked car into a magical, flying one is very,very wishful thinking. We would settle for it driving 55 mph at thispoint, and having it stay on the road would be an even-bigger bonus!

While the economic situation he's inheriting makes one wonder whetheranyone else will ever again want to grow up to be president, the restof us are looking at our trading accounts and finding comfort in thefact that at least we don't have to balance a budget on the nationallevel!

A Twist on 'Buy Low, Sell High'
As a trader, you've probably been advised to "buy low and sell high" somany times that your eyes automatically roll when you hear the phrase.Let's face it, who doesn't want to buy stocks or options "on the cheap"and close the positions for double or triple their original value?

But what a lot of folks outside the options world don't realize arethe, well, "options" behind "selling high." And there, friends, iswhere you have a unique advantage over thousands, if not millions, ofinvestors who are neither talking the talk, nor walking the walk.

We love to watch the "smart money" to follow those cash-flush investorsinto profitable trades. And with the market having some of its worstdays in more than two decades, it's only natural for us to see what thebig-money players are buying.

And lately, they're selling.

Now, before you access your online brokerage and tell your account repto liquidate everything, keep in mind that "selling" isn't just cashingout. In options-speak, it's also called "writing" or "shorting" options.

Exercise Your 'Writes' as an Options Trader
You may already be "selling high" by "selling covered calls" againstthe stocks you hold long as a way to juice up your returns when sharevalues are flatlining or pulling back. In a word, when you sell a callagainst your shares, you collect premium upfront and look for theoption to decrease in value.

But what a lot of folks outside the options world don't realize arethe, well, "options" behind "selling high." And there, friends, iswhere you have a unique advantage over thousands, if not millions, ofinvestors who are neither talking the talk, nor walking the walk.

We love to watch the "smart money" to follow those cash-flush investorsinto profitable trades. And with the market having some of its worstdays in more than two decades, it's only natural for us to see what thebig-money players are buying.

And lately, they're selling.

Writing Options
Now, before you access your online brokerage and tell your account repto liquidate everything, keep in mind that "selling" isn't just cashingout. In options-speak, it's also called "writing" or "shorting" options.

When you sell (you'd tell your broker to "Sell to Open" your option),then you get to keep your premium and sell more calls against yourstock next month, and the month after that. Or if the option still hassome value left at expiration, you can "Sell to Close" your calls for alower value at any time during the life of the contract, and still keepsome (if not most) of the money you took in when you initiated thetrade.

In fact, when you're writing calls or puts, the lower the option'sprice goes, the better for you as the options trader! Why? Because theless the option is worth come expiration Friday, the better for yourtrading account.

Use Options to Bet on a Stock Bottom
Here's an example of how "selling high" means anything but selling out:

With tons of busted stocks out there that are trading at seeminglyunfair prices, suppose you think one in particular just has to go up.With consumers increasingly staying at home, suppose you think Netflix(NFLX) stands to benefit from families gathering around the televisionduring the winter months. (Note that this is not an actualrecommendation.)

With NFLX trading at $20 -- half of its 52-week high of $40 -- you maythink Santa's going to be good to this company. So, you may decide topick options with a January expiration date (to take advantage of theholiday season), and thus choose to sell the NFLX Jan 20 Puts for $2per share ($200 per contract).

Your goal as a put seller is to have the stock go up during the life ofyour options contract so that the $2 that's credited to your tradingaccount from the moment you initiate the trade stays there. If thestock keeps going up, the value of the put erodes but the money youcollected is yours to keep.

How is that possible? Because think about the position of the putbuyer. We buy put options as a bet that a stock is going to go down. Ifthe stock trades up, the option becomes worth less and less,particularly as expiration nears, as options lose their value even morequickly than usual.

In fact, when we're selling options, we typically try to stick withexpiration dates that are close to the date we're initiating the trade.If it's November, we may sell a December option, or sell a Januaryoption in December, to capture premium on options that don't have a lotof time left till expiration.

So, Why Not Buy Calls?
Selling puts, as in the example above, is a way of capturing a stock'supside. So why not just buy a call option, then, if we think a stock isgoing up?

You're probably more familiar with buying calls, and it's a finestrategy. But when you're buying calls, you're laying out money fromthe moment you enter the trade, whereas you're collecting money byshorting an option from the get-go.

Your risk is limited when you buy calls, whereas the risks are muchhigher when selling puts. However, some of the savviest, smart-moneyplayers out there are writing puts to establish a long stock positionin the names they wouldn't mind owning at the option's strike price.(In NFLX's case, $20 per share.)

'Stock' Up on Shorts This Season
In these days of high volatility and, as a result, high optionpremiums, collecting this premium upfront (i.e., "selling high") ismuch-more preferable to paying those high premiums to buy options atthis time.

So, what happens if you sell (to open) those Jan 20 Puts and the stock goes up to $25 or even $30 before January expiration?

Then those options won't be worth a thing, but no one can take yourpremium away from you. When expiration comes and goes, that money isofficially yours to keep.

But what if the stock goes down in the meantime?

That's why you don't want to buy too much time, as it can work againstyou. But even if the stock goes in the wrong direction, you're notstuck with a dud of a trade. You can tell your broker you want to "buyto close" your short puts at any time.

If they've decreased in value, then you are still a winner, as youwould be able to keep some of what you collected when you unwind thetrade. When shorting options, the most you can make is what you collecton the day you initiate the position. And nothing makes a seasonmerrier than making 100% profits on a trade that goes your way!

Don't Get Stuck with a Lump of Coal … Unless You Want to
But what if the stock took a nosedive and the value of the options wentup? Then you've got some decisions to make about how -- or if -- youwant to make your exit. Remember, when selling puts, you should onlysell an amount that you are comfortable owning if the stock is put toyou.

You don't have to own the underlying stock to sell calls and puts, butbecause there is risk involved, you will need to be approved for amargin account and Level 3 trading status.

Check with your online brokerage before doing any of these strategies,but once you see the payoff that selling volatility can make, you'llsoon see how selling volatility can bring new life to your portfoliowhile the market sorts itself out!

Brainteaser

What Options Traders Want To Know

by Stan Freifeld


With volatility trading at historic levels I received quite a fewquestions and comments about trading in this market. This week I'llrespond to several. Keep in mind that this market in general has beenvery good for options traders, but we are trading in somewhat unchartedterritory and just about anything is possible.

It's tough enough trading when we know the rules, but when they'reconstantly changing, watch out. Since 1973, when exchange tradedoptions first started trading, volatility has not traded at this level.Despite what you may hear on TV and the news, no one has traded throughthis scenario before. Therefore, you may be right to be skeptical ofany expert who claims to have all the answers.

Iron Condors
Q. I've been trading Iron Condors, mostly on indexes, for several yearsand have made consistent profits. In September and October, I havegiven back over a year's worth of profits. I thought Iron Condors onindex products were relatively safe. They don't feel so safe anymore!

A. I'm sorry to hear that you've lost a significant amount of yourprofits; this market has been very difficult for a lot of traders. Todate, I haven't described the Iron Condor strategy in my recent seriesof articles. The Iron Condor consists of selling an out of the moneyPut credit spread and an out of the money Call credit spread.

For example, with the XYZ Index at 800 you may sell the 640/650 Putspread and the 950/960 Call spread for a credit of say, .95. If theindex is between 650 and 950 at expiration, you keep the full credit.However, if the index closes below 640 or above 960 at expiration, thespread that you sold for .95 will be worth $10 and you take a loss of$9.05. Ouch!

Since these spreads are usually done about 45 days prior to expiration,Iron Condor traders usually have positions in 2 expiration months on atthe same time. If the index makes a large move quickly, either up ordown, both months can show significant losses. Obviously, the big movein this case was down. The moves were so large and so quick thatdefensive action was hard to employ.

An Iron Condor is a high probability, small profit strategy. Like manyother strategies of this type, they work great until they don't. I knowthey're very popular with the trading public, and I'll be writing anarticle fleshing out the details and providing some defensive andadjustment strategies. Overall, I'm not a huge fan, although I do usethem from time to time when the conditions are right.

Trading In High Volatility Environments
Q. With volatility as high as it is today, what strategies do you recommend? Thank you.

A. It sounds like you're making an assumption that volatility is likelyto come down. I'd have to agree with that since it can't stay up hereforever, or can it….? To take advantage of this predicted decline involatility you want to employ strategies that have a large amount ofnegative vega. That would include short at the money Straddles andStrangles. The problem with these strategies is that they leave youexposed to large directional moves. One way to mitigate thisdirectional threat is to buy some directional protection, i.e. out ofthe money Strangles.

The combination of the short Straddle and long Strangle is called anIron Butterfly and the short Strangle and long Strangle combination isthe Iron Condor. These positions are done for credits and the adjective"Iron" refers to the fact that the positions are composed of Puts andCalls. The subject of a future article will demonstrate thatButterflies and Condors can also be constructed entirely with Puts orwith Calls, and that regardless of how they are composed, the riskprofiles, and the Greeks, will be very similar.

There are two other common negative vega strategies that you might wantto consider. The first is the reverse calendar spread, which is justthe opposite of the typical calendar spread. In this case you buy thenear month and sell the far month. A problem with this position is thatthe margin requirements are quite large since the short option is notconsidered to be covered, and therefore is margined as a naked option.Another strategy is the ratio vertical spread, which involves buying anat the money option and selling two out of the money options with alloptions having the same expiration month. This is best done with Callswhen you're not expecting a large upward move and with Puts when you'renot expecting a large move to the downside.

VIX & The Market
Q. In the past, it seems that when the VIX moved up, the marketgenerally rallied shortly thereafter. Is it time to start buying again?

A. It is true that in the past, after a spike in the VIX, the marketwould rally. However, in the current environment while the VIX hascertainly moved up, and done so quickly, it has stayed at a relativelyhigh level. Consequently, it's not yet clear that this is a "spike."Even on the assumption that this is a spike, there is some conflictingevidence that perhaps, not enough data is available to make anystatistically significant conclusions regarding how the market reactsto the VIX, and if there is a cause and effect relationship. Keep inmind that the VIX has only been around since 1993.

Short Deep In-The-Money Calls
Q. I am short deep in the money naked call options. What happens on expiration if I don't cover them?

A. If you don't cover your naked Calls by buying them back, you will beassigned on expiration Friday, and on Monday morning you will wake tofind that you have a short stock position. If you had long stock inyour account on expiration day, then your stock would be called away,and you would have a flat position on Monday morning. Keep in mind thatyou may be assigned prior to expiration day since your options are deepin the money and may not have very much time value. The probability ofassignment is much greater if there is a sizeable dividend payableprior to expiration. The only way to ensure that you won't be assignedis to buy back the Calls.

Volatility Skew
Q. With a stock trading at $48, I recently sold some 55 strike coveredcalls. The expiration was in 31 days. The next day positive news on aphase 2 trial was announced and the stock jumped $3. However the valueof the option fell by nearly 30%. How can that be?

A. The short answer is that the implied volatility decreased. It soundslike you're referring to a biotech stock. It's generally true thatprior to a major announcement of this type the implied volatility getsbid up to extreme levels. After the announcement, volatility usuallycomes back to the stock's normal trading range. It's quite common fornovice traders to underestimate the impact of a change in volatility. Iran some quick calculations on my options calculator and if the impliedvolatility was 80% before and 50% after the announcement, the optionpremium would decline from about $2.15 to $1.50 even though the stockprice increased from $48 to $51. You can see that the impact of thechange in implied volatility easily outweighed the price change of thestock. That's why understanding the impact of changes in volatility isso critical when trading options.

As always, if you have any questions about my articles, havesuggestions for future topics, or want more information about ouroptions mentoring program, feel free to email me at:sfreifeld@tradingacademy.com or call me at: (888) OTA-2580 ext. 2010.

多吉

thanks for sharing. very informative to the subject...

tobetrader

谢谢

egghead1

great piece. thx.

Fan8an

thanks

Control_Risk

Great. Thank You.

oldfox

Brainteaser

thanks for sharing. very informative to the subject...
多吉 发表于 2009-4-18 08:32

这个basic 的information 估计对老大没有用.

前几天我记得在胡同看到一个帖子说,大众错过rally 是因为vix的原因.


周末转载一下看到的vix 方面的post

49north

Thanks！ 好文章慢慢再看

小咪

9# Brainteaser


谢谢！ 收藏