Nike Straddle - Just Do It?

Todays posts have reminded me of an interesting situation a poster over on EliteTrader has gotten himself into. What reminded me was the confluence of Wallstrip's latest topic, i.e. Nike (NKE) and Adams post on vega which I posted about below.

Here is what a trader did on the 20th Dec as reported in ET:

Just bought NKE Jan 100 straddle for debit of 5.82. Option prices seem relatively cheep (sic) considering its right before earnings announcement. Any ideas on how it might play out? All comments are welcome!

To which one of the experienced hands replied:

Learning exercise.

Go to www.ivolatility.com and enter NKE in the ticker symbol location. Then look at the chart for historical IMPLIED VOLATILITY. Then compare where the IV is today for NKE compared to where it has been a few weeks ago.

To cut to the chase, current IV is at 25% or so. Last month it was at 16%. The high for the year is 28% last December (presumably before earnings) and the low is just under 16%.

So you are buying a straddle when IV is near historical highs.

In December of last year, IV crashed from its high of 28% or so to about 18%.

So what does this all mean. High IV means premiums are higher in value relatively. When earnings are released IV crushes. So your straddle will most likely go from an IV of 25% to somewhere below 20%. If you are not sure what that means, plug your straddle in an option calculator and change the IV from 25% to 19% and see what happens to the value of your straddle. It will drop sharply.

So before putting any money into a straddle you should study volatility and the effect it has on option prices.

Basically with respect to volatility you are buying high and gonna sell low after the news. So you need a real nice stock move to overcome the volatility crush AND time decay that will start creeping in...

...and that is exactly how it played out.

The poor guy bought the straddle on the 20th for $5.82 with the underlying at ~$100.00. Today with the underlying still ~$100.00 the straddle is worth about $3.60.

What happened? Implied volatility crush; which often happens once earnings are released... and if the stock doesn't move, or it doesn't move *enough, the trader gets smacked on long gamma positions (bought option positions like straddles).

This is what is termed "vega risk", the possibility that implied volatility will drop on your bought options (or rise on your short options) and cost you money, independent of any stock price movement.

The flip side of the coin is that it can also work in your favour. The trick is in understanding it as a risk when entering positions.

Reasons To Not Chase Big CC Premium - RE - REVISITED

The latest Big IV stock the Buy/Writers have been chasing premium on is Telik Inc (TELK) with IV 's in excess of 200% on the table. I've batted on about these Buy/Write strategies ad infinitum to anyone prepared to listen (and a great number who weren't lol) down here in the antipodes for years now.

I stress though, there are other ways to play these huge IV's, but Buy/Write is the silliest way in my opinion. Why? Because of the uncovered downside risk.

This last few days has been a treasure trove of examples of this and these have been trades that have been discussed extensively on various trading fora during the last month. First (NUVO), then (NFLD) and now we have (TELK), which released news today. (Hat tip to Adam Warner)

The picture says more than words ever could:


That's three train wrecks in the space of 8 days and it's quite possible that readers of those forums I mentioed could have traded all three. OMG!!!

Those Pesky Greeks

Or so Adam Warner describes them. Well, they are pesky when options snatch money from you and you haven't a clue how it happened. I spent quite some time bewildered like that. lol

Anyway, Adam has committed to offer up some explanations over the coming week, starting with vega. I always think it's good to go over these definitions numerous times from different writers, you often pick up a new and useful concept.

Keep an eye out for the other greeks as they come on line.

Another Look At Historical Volatilty

Adam Warner said something yesterday that has re-ignited a thought process I've had bubbling away in the back of my head for some time.

Historical volatility is not a perfect proxy for the volatility of a stock. It factors in the daily range but DOES NOT tell you how it got there.

In other words, a $50 stock with a 50 cent range that doesn't fluctuate at all intraday would spit out the same historical volatility as a similar price and range stock that has many intraday moves up and back within the range. But clearly the second stock affords better trading opportunities.

So when I use historical volatility as below to guestimate the ability to make money flipping a stock, it is just an approximation.

Historical volatility a.k.a. statistical volatility is after all, a theoretical statistical measure and says little about the direction or trendiness of price movements. As such, it may not accurately reflect the the time period it is actually measuring.

For instance, a stock can put on a great move over the period of 20 days, yet statistical volatility can be at lows. We need look no further than the S&P500 in the last few months

This can have implications for option sellers trying to select appropriate strikes. Of course the big problem is not being able to see in the future, as short strike smashing trends can develop from absolutely nowhere. Condor traders on the S&P are getting crunched, yet statistical volatility is suggesting that a condor ws a good trade.

This has all got me thinking about a more appropriate measure of volatility that can account for trendiness of price movement. But will it be useful?

Just something to think about as I zone out from the familial bickering that is inevitable during Christmas dinner.

Any thoughts?

Reasons To Not Chase Big CC Premium - REVISITED

With Northfield Labs (NFLD) near month implied volatilities at in excess of 200%, Buy-writers have been all over it like a rash, chasing the huge premiums available.

One thing folks forget who chase this type of trade is the risk inherent in this strategy, that's why the IV's are so high.

Well guess what? Northfield (NFLD) is down some 50% in after hours due to some bad news via last nights conference call... and this is IN ADDITION to the 20% whackage during the day.

Now, imagine if a trader had been in (NUVO) and (NFLD) covered calls! That would be two big losses in one week.

Ouch!

{edit} Just wanted to put up a chart of the fun... NFLD 15min including after hours session.

Reasons To NOT Chase Big CC Premium

I often see posts on the various forums about folks chasing extreme IV to write Covered Calls.

This is often not a very good idea. Why? Well despite being able to collect huge premiums, there is a huge amount of risk.

Check out this one:



It's Nuvelo Inc (NUVO) and this was a disaster for those chasing big premium.

Sometimes I'll have a go at these and play the IV crush when the announcement comes out, BUT with limited risk strategies.

CC's are Russian Roulette in this circumstance... trying to snatch a bone from a pit bull. A bad idea.

VIXatious VIX

Adam from the Daily Options Report was alert when he spotted some overbought VIX last week and has noted the now oversold condition here, and therefore possibly short term bearish.

This was also not lost on the folks at Trade King, nor the "sages" at Bloomberg who think it bearish as well.

The Chicago Board Options Exchange SPX Volatility Index yesterday closed below 10 for the first time since 1994, signaling that fund managers are too confident stocks will rise.

Low volatility ``suggests that investors are getting a bit too complacent,'' said Ian Sharman, who helps oversee $1.2 billion at Royal London Asset Management and owns U.S. stocks. ``The market is climbing a wall of worry.''

The VIX is based on prices paid for Standard & Poor's 500 Index options. In the past, lows in the VIX have heralded stock- market declines. There were sell-offs in May of this year, in 2001, in 1998 and in 1997 around the time that the volatility measure reached lows for the year. ===>>MORE<<===

I note the cautious to downright hedged tone to these calls (rightly so) because it is not as reliable a signal as very high VIX.

Along the same vein, when *everybody is thinking the same way, it's often a good time to fade.

I hope not, I'm positioned for sideways to more upside in most positions.

Implied Volatilty

Volatility has more importance than just calculating statistical probabilities of price movement in options trading, it is actually one of the inputs into the Black Scholes Option Pricing Model (or BSOPM) I shall hereafter use this acronym as proxy for any of the various option pricing models. (American style options are more likely the be priced using the Cox, Ross & Rubinstein binomial model, but the difference is not great)

For future reference the six inputs into BSOPM are:

Price of the underlying Asset
Exercise price
Time till expiry
Dividend amount/date
Risk free interest rate
Volatility

In determining a price for an option all of the above must be put into the pricing equation to derive an output price. However there is a problem here. The first five inputs are absolute, as these values are known at any one point in time, but as the volatility input required is the forward volatility.

In other words we need to know the volatility of the underlying between now (the analysis date) and expiry. As this is in the future, it cannot be known. Therefore an estimate of this future volatility must be made, using tools such as statistical volatility and the traders best guess as to what trading conditions will be.

In reality, option prices are set by supply and demand, as well as the influence of arbitragers who will quickly leap on pricing anomalies.

The net result of this is that the volatility figure as input, is worked out from the other five inputs and the option price, using algebra. This is called "Implied Volatility". It is the volatility "implied" by the options tradeable price.

Most of the time, the implied volatility of the option "tends to reflect" the actual statistical volatility of the underlying. This means that they will be reasonably similar, but with some forward looking by option traders that will make for some degree of difference, as shown in the chart of (BHP) volatilities below.
The image above is a one year chart with the 30 day statistical volatility plotted in blue and an average of option implied volatilities in gold.

There are times when option traders may be expecting a sudden change in volatilities, such as when an earnings announcement or FDA decision is due. This will be reflected in implied volatilities being a great deal different to the statistical volatility as shown in the Rambus (RMBS) volatility chart below
You can see that IV was rising from the middle of March as SV was declining to quite low levels. The stock went quiet, yet option traders were expecting action, which eventually arrived with a sudden lift of SV in late April. Notice however that IV raised to much higher levels than the eventual realized volatility. This is the type of situation that can be traded, using the greeks; this is also the type of situation where the unwary have their money taken from them.

The purpose of analyzing volatilities in this way is paramount in selecting appropriate strategies and defining risk as a function of the greeks.

Many beginning and/or short term option traders imagine that these factors do not apply to them, or are merely complicating what may be kept simple. It is these traders who ultimately blame market makers for some of their bewildering losses, (Been there, done that, got the t-shirt) but as shown, it is just a factor of option pricing that must be known.

Next we'll have a look at the greeks, starting with Delta.

Volatility

Perhaps the most neglected, yet most important aspects of options trading is in the area of volatility, its analysis, and consideration when trading. Intrinsic in using volatility in option trading, is an understanding of the greeks. This is why volatility is often ignored or misunderstood, because of the difficulty in grasping what the greeks are all about and how they affect every option trade you undertake.

Yet they are really not that hard to grasp individually, and it is only a matter of practice to consider all the greeks together when analyzing a trade.

So why am I banging on about greeks when the title of this article is volatility. It's because volatility also has a greek name, so therefore should be considered amongst them. That greek name is "sigma".

Sigma is the measure of 1 standard deviation of price movement, annualized and expressed as a percentage.

What is volatility?

Expressed in the most simple terms, volatility is how much a stock moves around in price. We can say that a stock that moves in a range of $70 to $75 over a period of months would be considered as a low volatility stock. Its movement is relatively quiet and sedate. Another stock that moves in a range from $35 to $90 in the same time period would be considered a lot more volatile. This would be a high volatility stock.

Technicians have various methods of measuring volatility; average true range, standard error, standard deviation plus a few others. But in the option world there is a specific formula for measuring and annualizing volatility. This web page explains the mathematics, or, if you have a charting package it can be plotted as an indicator.

This formula is known in the options trading world as "Statistical Volatility" or "Historical" Volatility. The two terms mean the same thing and are interchangeable

If you have Metastock or Amibroker, the formula for 30 day statistical volatility is as follows:

(StDev(log(C/Ref(C,-1)),30)*sqrt(252))*100

What is meant by "30 day" volatility is that the last 30 days volatility is measured and converted to give an annualized percentage figure; "sigma". Lets have a look at Statistical Volatility on a chart.


As you can see this measure of volatility varies as the retrospective period of 30 days is moving. So it can be viewed in a similar way as a moving average... sort of. But what you can see is that volatility varies. Typically a stock will oscillate from a period of relative low volatility to periods of relative high volatility. This information is useful for evaluating the value of options and for the timing of trades.

Questions are welcome.

Next we look at Implied Volatility.

Thanks For Visiting But...

I see in my sitemeter stats that I am getting quite a few hits since re-starting this blog; obviously from people who still have rss subscriptions from the old blog.

Well thanks for visiting, I really appreciate it :) But give a me a few days to reconstruct my pages... most posts will be basic stuff for a few days before I get into any real content.

But be sure to stop by again soon and see how I'm progressing.

Nice to be back on-line.

Disclaimer

My posts are purely for entertainment value only and not to be construed as investment advise.

Only an idiot would take them seriously and actually make investment decisions based on what I write. If anything actually seems to make sense, smack yourself on the forehead before it's too late. Even I don't take myself seriously anymore. :)

Do your own research.

Contact Details

My email address is:

lingrovetrading---AT---yahoo.co.uk

Simply remove the ---AT--- and replace with @

Why Mk III?

Well this is "take 3" at blogging.

I have managed to nuke 2 previous blogs by messing around with the Wordpress PHP code, something I know nothing about.

Ready to toss in the towel, and being off-line for a few months, I was convinced to give the Blogger platform a go from a friend who's blog template I've borrowed heavily from... kudos to Avalon Trading.

So far so good. (lol this is the first post) It does seem much easier to work with.

This time I'll avoid fooling around with the code :-P

I trade options on both stocks and indices for a living. As a general principle, I will try to be a net seller on indices as a premium collection strategy, and on stocks I select strategies based on volatility conditions and my technical view of price action.

My first point of analysis is volatility, to see if I can identify opportunities from over or under valuations, or to take advantage of the volatility cycle.

Hopefully the content here will be interesting and useful... and with any luck, I won't upset anybody.... hmmmm.