Sigma Options

Blogging At A New Space

2012-01-05T12:37:00.000Z

I have recommenced blogging and for various reasons have started a new blog called

Options - The Naked Truth

Visit me there at optionsthenakedtruth.blogspot.com

November Soothsaying... Or Not.

2009-11-02T00:44:00.003Z

As October trading is over it's time to look forward to the next month with reference to our new monthly pivots now set in stone, with the last trading day in October adding a fair bit of interest to the equation.

The monthly pivots have been very influential on the resistance side of the equation, but with scarcely any relevance at all on the support side. This is fairly expected in a stong uptrend.

click to enlarge

First line of resistance is 1085 and my guess is that that would well and truly contain this market based on the last few day's action.

Maybe we see the support pivots coming into play... maybe. First support at 1003. Anyway, they're my points of reference to watch out for.

The 20dma of the equity only put/call ratio is still dragging it's ass along the lowest levels of the last 3 years and that still says to me that the market is toppy.

But those low readings can and do drag on.

VIX is the interesting one having hit 30 on Friday. VIX gave a pretty reliable short term buy signal that manifested itself on Thursday of last week, but that all turned to crap on the Friday. The VIX is about 50% higher than current realized vols (on a 20 or 30 day lookback basis); I don't know whether that means options are a sell, because realized vols could just pick up a canter from here... perhaps even gallop off into the sunset.

All in all a pretty interesting week and month ahead. No soothsaying from me at this point apart for not expecting new yearly highs in the month of November... but I don't really think the market is ready to sell of in a major way just yet.

Discuss this and other topics at International Stock Forums. Help our new forum grow with your input.

Cashing In My Chips

2009-10-30T20:06:00.005Z

The big news of the day in optionstraderblogoshere is the VIX pumpage.

Usually I would try to come up with some insightful market maxim, or a chart with pretty lines highlighting some statistical gobsmacker.

Today I offer none of that. The only thing that mattered to me was that VIX HIT 30!!

...and I won the bet. :)))

Perhaps I should gloat, or give Mark a digital hard time and poke fun ad nauseum. Instead, it is relief that it got there first and saves me some embarrassing payout on my bet with Mark.... fear of loss or some such psychobabble.

It was a bit of a hoot, but I'm cashing in my chips and quitting while I'm ahead.

High Stakes VIX Bet

2009-10-29T00:27:00.007Z

The story of the day from the options trader's perspective is not the crimson red condition of the stock indexes, it is the VIX pumpage into extremely oversold levels as detailed by Bill Luby.

Adding poignancy to the situation I have been lured into a wager with Mark over at Option 911. The bet is that VIX will hit 30 before it hits 17. Convinced I would have my ass handed to me, I obtained very favourable odds; the payout, something moderately embarrassing if I lose compared to something really really REALLY embarrassing if Mark loses.

Right now, I'm feeling quietly and unexpectedly confident. :)))

N.B. - Neither Mark nor I are likely to be fooled by the randomness of such a wager, just a bit of frivolity folks.

Whither Gold?

2009-10-28T00:05:00.005Z

Although gold option volatility has settled into what looks like a base of around 20%, it is still usefully above realized vols at around 15-16%... useful depending which side of the trade your on and presuming realized vols don't startle us all into a dither.

Aside from what has become the normal 4 or 5 points premium, there doesn't seem to be a lot of buying interest in gold options (specifically calls), despite the gold-bug's scaremongering and ramping.

Price action on the other hand looks to be approaching an interesting point at the old resistance becomes support observation and this is still in a technical uptrend. Countering this is a few voices such as Roubini who have been talking Gold down.

I've exited my option trades now, so nervously contemplating my next move. I don't want to miss a good party thrown by the gold bugs, but on the other hand, I can't help feeling a bit skeptical about $5,000 gold or whatever number get pulled out of people ass.

Short gamma doesn't excite me right now.

So, whither gold?

VIX Stirring From its (Relative) Slumber

2009-10-26T17:04:00.005Z

Do I detect just a modicum of concern of this market via the VIX?

Yes we are off a few points today and this invariably causes at least a bit of a rally in the VIX. Nothing startling there. But watching VIX over the last few days I was beginning to wonder whether they were going to plough volatilities into the mid teens, come what may.
We all parrot the standing wisdom that VIX is mean reverting and I certainly think that's true. The nature of volatility and how it is measured makes it deterministically so... with an infuriatingly chaotic dualism so we can never really time volatility except by accident.

('cept when I nail it right on the day. That is unquestionably skill )
What is this mean VIX must revert to anyway? Having not really paid attention during may statistics classes, I never realized there was more than what type of mean. Sparing me the embarrassment of intellectual incapability of calculating other sorts of mean, I am quite sure it is the arithmetic mean of some defined lookback period, AKA a simple moving average.
Easy enough to work out, but even that simple task has been wrested from us via software.

But it begs the question, what lookback period should be used to determine the mean? In other words, what length moving average?

There is a school of thought that uses the 10DMA. Fair enough... whatever. But the lookback period used can deliver vastly different "means". Also the mean is a moving target. The mean today scarcely resembles the mean 8 months ago. By the ten day measure, VIX is probably already overbought (whatever that means). By other measures, there is still some reverting to do.

Whatever the case, the VIX mean is heading lower, unless Roubini's 2nd crash scenario unfolds; and don't see that happening in the near future.

What I'm basically saying in an extremely convoluted way is - VIX has finally bounced, but I have no idea where it, and the market, is going next. But my guess is some degree of retracement.

Discuss this, and other topics at International Stock Forums.

The New VIX Reality

2009-10-21T18:33:00.002+01:00

An excellent post over at VIX And More about anchoring and expectations etc, anyway, Bill talks about the new VIX reality at it tanks towards 20%.

Previously, I've spoken about using technical analysis on the VIX, so long as it is only about creating boundaries of prove and disproof. Well, a solid break below what seemed to be a base of around 23% certainly disproved the 23% base hypothesis.

The new one is to expect declining average VIX levels. Despite every bit of negativity in the real economy - green shoots or not - stocks just want to grind upwards.

Some are prompted to predict a multiyear bull on that basis... whatever. But right now, folks are comfortable with buying stocks.

Selecting Condor Strikes - A Study

2009-10-21T18:00:00.003+01:00

As I have outlined in another thread, people who trade iron condors are usually taught to select short strikes at one standard deviation from the current price action.

As I am developing a conversation elsewhere, I think extrapolating option volatility to "monthized" levels is not optimal.

What I want to do in this thread is select hypothetical strike levels, assuming that an iron condor is put on on the expiry Friday of the previous cycle. Some people like to initiate ICs with 2 months to expiry, so we'll have a look at that too.

I'll be using historic volatility, just so it can be automated.

I'll report on how these strikes are threatened or not as time goes by, to test how well this selection process works.

Note that this does not represent any trades I may be doing, it is just an exercise.

On the chart the red lines are 1 standard deviation (68% theoretical probability of staying inside).

The Blue lines are 1.28 SDs (68% theoretical probability of staying inside), which you would probably never get enough premium to trade.

The Green lines are at 0.6 SDs and represent what a low probabilty condor trader might select. It is presumed this trader is prepared to adjust more aggressively.

The top chart with heavier dotted lines is to represent a trade initiated 16 Oct with Nov expiry. (1 Month)

The 2nd chart with lighter dashed lines is to represent a trade initiated 17 Sept with Nov expiry. (2 months)

The 3rd chart lighter dashed lines is to represent a trade initiated 15 Oct with Dec expiry. (2 months)

I have also posted this at http://www.internationalstockforums.com/index.php/topic,29.msg64.html#msg64 That will be an easier place to follow allong as time goes by. Comments most welcome there.

Click to expand image.

S&P500 Soothguessing

2009-10-19T11:00:00.004+01:00

(Also posted at International Stock Forums.)

As we head into the new week, once again I pull out my crystal ball (which I'm thinking of sending back for a refund) and look for signs of a top in this market. Ahhhh life is so tough for bearish prognosticators. Once again I'm going to have a look at those leading indicators than markets are so adept at ignoring.

Firstly, VIX. As I said in a previous post, I have no challenge with technical analysis on the VIX, so long as it is about creating boundaries of proof and disproof. My thesis was that VIX had bottomed for now at ~23%. This has now been disproved with Friday's close at around 21.4%. VIX watchers are postulating that it is now oversold on whatever their favourite basis is for such opinions. I'm inclined to agree.

Even if we get a mean reverting bounce in the VIX via a retracement in the Spooz, you'd have to think there is generally lower levels in the VIX's cards as the market grinds upwards.

My old favourite, the 20dma of the put/call ratio is still dragging its ass along some of the lowest levels of the past three years. Clicking down a couple of gears to the 5dma of the put/cat ratio and we are at new lows as of Friday's close.

Nobody wants to hedge their portfolio any more.

This gives us a picture of complacency and this is generally regarded as a contrarian signal. It should be noted however, that complacency can last for some time.

The case for resistance can be made by the monthly pivots. These have shown areas of interest in the past few months and as we are at R1, I'm looking for some genuine signs of resistance. We've had a bit of a pause there during the latter part of last week, but I've yet to be convinced we don't grind higher. Markets have opened up a tick or two as I write, so waiting to see definitive signs of direction for this week.

Good luck

Gold Volatility 14 Oct '09

2009-10-14T21:46:00.004+01:00

Gold volatility went into the tank today and with gold not far off those all time highs one has to wonder why. Below is the Chart of GLD with CBOE's $GVZ (The gold VIX).

The $GVZ plonked to 20 and a bit and while that is still a fair way above 30 day historical volatility at 16%, it represents a fall to close to the "normal" premium of IV over HV in gold options.

You'd have to suspect at least a pause/retracement from here if that means anything at all. Perhaps the talk is some quarters of a bottom in the dollar is easing concerns, though the dollar is still taking it where it hurts.

Countering that is the seasonal tendency in gold which resumes an upward bias right up to Christmas (depending whose dodgy data you use).

I'm still bullish after some sort of pull back. Markets just want to go up right now, but option traders seem skeptical.

The Intel Torpedo

2009-10-14T11:13:00.003+01:00

The bulls will be feeling all warm and fuzzy this morning as it looks as though Intel earnings will be giving the Spoooz a leg up over resistance and to a new high for the year, if the futures right now are any guide.

Of course it means my double top scenario has taken a torpedo to the magazine case... a direct hit. Never mind, I'll keep my guru robes in the bottom drawer just in case I get a market call right one day. I should have just taken the Abbey Joseph Cohen line and basked in my correctness.

This also means the VIX will sink below the 23% water line, in fact has already closed below yesterday.

Man the lifeboats and board the good ship PollyAnna LOL. I give up, I'm turning bullish.

(Which could just be a great sell signal).

However, worry not for my finances. Realizing how crap I am at market calls, I continue to be delta neutral on the indexes. All this stuff is for amusement only.

I love options :).

(VI)X Marks the Top?

2009-10-12T20:17:00.005+01:00

So the S&P500 just about touches the high of the year from last month and slowly backs away. At this point I'm not going to remind you of my top call from September 30, just in case it blows straight through to new highs and trashes my reputation as market soothsayer and guru. LOL

The point of focus for me is now VIX. The finer points are expertly covered by Adam Warner and Bill Luby (and others), but I'm looking at the 23% level and wondering whether that is the base level for right now.

Which begs the question. Is the VIX predictive or reactive... or both. I lean on the side of reactive, but the mean reverting characteristics are well known, hence indicating as least some predictive implications.

The next question is "can technical analysis be used on the VIX?"

I say why not?

I say you can, so long as you're not trying to make predictive assumptions with pretty coloured lines and purely mathematical constructs. To me TA is about create boundaries of proof and disproof. This fits in with VIX analysis for me.

IOW a break below 23% disproves my basing hypothesis. A bounce above supports it.

Adam and a few others use the "10% above or below the 10dma" method to spot potential points of over/undersoldedness (to invent a new word). I'm far too lazy for that so I've tacked a 3,10,16 MACD on the bottom to essentially arrive at similar conclusions. It works adequately for that purpose.

Do we see an oversold VIX? Yes. Does it mean anything? Who the hell knows. But there is that divergence on the bog standard MACD.

The upshot is that I'm trying to convince myself of the chance of a double top right here.

Yes, I'm fighting for my guru call's survival...

...somehow I fear it may be in vain. This market just wants to go up.

Making Plans For 2013

2009-10-12T15:31:00.002+01:00

It seems the lucky ones amongst us will be graced with a few more years past 2012.

Yep it seems that the end of the world has been postponed and not going to be in 2012 after all, LOL. That's according to Mayan elder Apolinario Chile Pixtun.

Bugger! I was going to party hard until then, now it seems I'll have to nurse my liver for a bit longer.

2012 is not the end of the world, Mayan elder insists

The year 2012 will not bring the end of the world, a Mayan elder has insisted, despite claims that a Mayan calendar shows that time will "run out" on December 21 of that year.
Published: 9:49PM BST 11 Oct 2009

Apolinario Chile Pixtun is tired of being bombarded with frantic questions about the end of the world. "I came back from England last year and, man, they had me fed up with this stuff," he said.

A significant time period for the Mayans does end on the date, and enthusiasts have found a series of astronomical alignments they say coincide in 2012, including one that happens roughly only once every 25,800 years.

But most archaeologists, astronomers and Mayans say the only thing likely to hit Earth is a meteor shower of New Age philosophy, pop astronomy, internet doomsday rumours and TV specials such as one on the History Channel which mixes "predictions" from Nostradamus and the Mayans and asks: "Is 2012 the year the cosmic clock finally winds down to zero days, zero hope?"

2012 is likely to be an interesting tear on the stock market however... just like every year.

Guru S&P500 Prognostications

2009-10-09T16:51:00.006+01:00

In the absence of anything notable to report re my current obsession with gold, I'll have a look today at my guru call from Sept 30. (N.B. all the guru stuff is tongue in cheek and a bit of self derogation.) as you will recall I Went Out On A Limb and called a medium term top on the S&P500.

Well the bulls are putting that call under some serious pressure after some smugness inducing down days immediately succeeding my call. As of now, the yearly highs still have not been taken out, so I haven't cancelled my guru robe order just yet. I'm speculating on a double top and that divergence (for whatever that is worth) in the MACD does its freakin' job of psyching traders into a sell-off.

The 20day MA of the put call ratio I keep posting in the hope someone takes notice, is still highlighting extreme complacency.

So I'm sticking to my guns for now. Still no money on the outcome here, just managing a delta neutral trade. That means that don't want be toooooo right, sideways consolidation would be good.

Gold Volatility 8 Oct '09

2009-10-08T17:36:00.003+01:00

OK, so I have a thing about Gold at the moment. There is nothing unusual about that as half the universe has a thing about it at the moment. With gold grinding out new all time highs every day, there is nothing to be surprised about.

For me it is more about finding option opportunities, hence the prelection with gold option IVs.

I had an idea that with new highs in the underlying, we'd see new highs in implied vols as punters bought calls with their ears pinned back. This is not how it's playing out at this stage. This IV peak is lower than the IV peak in early September, even though the "actual" volatility of this move is slightly greater than the early September one. So, what this tell us?

Probably nothing.

But if any delusions can be derived from this, it is that option traders are toning down their expectations of more upside in gold. It should be noted that implied is still miles higher than realized with 20 day HV at about 17.5%, but this seem to be a chronic situation. IVs have consistently been higher than realized for quite some time.

The standard wisdom says that either IV drops or realized increases. It ain't necessarily so with gold.

No ideas for a trade *right now* but a few ideas depending on how things pan out

Gold Volatility Popping Again

2009-10-07T10:44:00.002+01:00

As we all know gold is breaching all time highs right now and leading on from my post yesterday http://www.internationalstockforums.com/index.php/topic,4.0.html there is some interesting developments from an option trader's point of view in that implied volatility (vis a vis option premium) is spiking well above current realized volatility.

Here is the last three months of volatility history on GLD (Gold SPDR)

As is obvious, implied volatilities are well over the odds. As you would expect, most of the meat is in the higher strikes as shown by this skew graph:

This means call option buyers, particularly OTM call option buyers need further dramatic rises to turn a profit, whereas on the face of it, writers would have an edge here. That's on the face of it. Who you be game to write call options here? Not this little black duck; not yet. I've got some naked put shorts I wrote at the end of august in anticipation of the seasonal gold bull, plus trading the moves with various strategies, but would I write more puts here?

Well I prefer to write puts at potential pivot point lows and that ain't here. (With the caveat that it has to make statistical sense to do so)

This situation is still developing from my point of view and worth watching for a nice writing opportunity. The $64,000 question is whether realized volatility catches up with implied, or whether gold bugs are just having another "Gold to $5,000 oz" party, are wrong again and IVs collapse back to current reality. We would need some very strong moves, relatively, to justify this IV.

Stay tuned.

Too Far, Too Fast

2009-10-04T19:38:00.003+01:00

So says Nouriel Roubini in an article in Gloomberg today. And even though everybody has already read, and just to display some confirmation bias (with my "top" call of last week), I think it's important enough to post here.

Roubini Says Stocks Have Risen ‘Too Much, Too Soon, Too Fast’

By Shamim Adam and Francine Lacqua

“Markets have gone up too much, too soon, too fast,” Roubini said in an interview in Istanbul yesterday. “I see the risk of a correction, especially when the markets now realize that the recovery is not rapid and V-shaped, but more like U- shaped. That might be in the fourth quarter or the first quarter of next year.”Oct. 4 (Bloomberg) -- New York University Professor Nouriel Roubini, who accurately predicted the financial crisis, said stock and commodity markets may drop in coming months as the gradual pace of the economic recovery disappoints investors....

Actually, I'm a bit surprised at his relative bullishness (or the reportage of the same) of late. This more moderate tone is a bit more of what I'd expect from him.

The Thing With VXX

2009-10-02T15:40:00.007+01:00

I'll bet you didn't know it, but the VIX has an ETN too

And if you'd care to take a dare I'll make a bet with you

Now the VXX is a pretty good fiddle boy, but give the VIX its due

I'll bet a fiddle of gold against your soul, that the VXX has negative roll too.

...with humble apologies to The Charlie Daniels Band.

Yep, just like some of the commodity EFTs. Bill Luby at VIX And More highlights the problem with VXX as both a hedging instrument and a longer term play. Anyone thinking of having a play with VXX should read his post.

The bottom line is that when you need it most, VXX is at its worst in tracking the VIX.

Read It Here.

For a bit of true poetry and some amazing fiddle playing:

The Creaking Limb Holds

2009-10-01T18:00:00.003+01:00

The sellers have come in to save my call. Phew, my campaign for gurudom is intact. Of course, having an iron condor to manage, I hope I'm not too blinkin' right.

Some consolidation right about here would be nice.

The greater question is the medium term prospects for stocks. We've come a long way and there is a lot of euphoria about, mixed in with some stubbornly pessimistic outlooks.

I'm doubtful that many of the problems which caused the financial cesspit we're in have been resolved in any way, and the real economy is still struggling. So the question is to what extent stocks will start to reflect reality - or some future version of it?

Which begs the whole gamut of existential and related questions. What is reality? What is value? Inflation or Deflation? etc etc etc

More importantly, when will the dip buyers step up to the plate?

The Limb I Went Out On Is Cracking Already

2009-09-30T18:32:00.003+01:00

Amazing market we're in at this time. There is dip buying, then there is dip buying.

Going Out On A Limb

2009-09-30T15:47:00.005+01:00

No, I'm not embarking on a mission of McLean-esque spiritual discovery, but I am taking the unusual step of publicly calling a medium term top on stocks.

Actually, I don't give a rats, I'm delta neutral and really would love some sideways consolidation ( a top of sorts I guess). I'm really just about managing whatever this ludicrous market throws at me. I just think that if that rich mental map that we traders think we have is worth a cracker (probably not), this really "feels" like it wants a decent retracement.

The $64,000 question these days is - what constitutes a decent retracement? Dip buyers apparently are cashed up and are all over any divot, never mind actual dips.

Lots of sentiment indicators are screaming "complacency", none more so than that 20dma of the put/call index I keep pulling up in the hope of a guru-like market top call. It's still entrenched at around it's lowest level of at least the past three years.

As mentioned in an earlier post, this is a pretty blunt tool, but usually manages to bludgeon the market into some sort of pullback. Add to this the "October Meme" and I think there is a reasonable case for a little bearishness.

N.B. For amusement value only, there is no money riding on this.

Coughing Up For Gold Options

2009-09-28T18:32:00.004+01:00

The recurring theme in stock index options over the last few months has been the chronic overvaluation as measured by implied volatility over the eventual realized volatility. Theoretically, this has been an excellent time for index option writers, except that the indexes have been running a long way from their mean. Any sellers writing fairly close to the money (like moi :-0) have been as busy as a one armed taxi driver with crabs, making adjustments.

We've had to work pretty hard for our money.

Index options haven't been the only ones in more or less chronic overvaluation. Gold options have been in a similar situation. I like the futures and their options, but the gold ETF, GLD and its options pretty much mirror the futs.

Check out the IV/HV chart for the last six months.

Even ignoring the IV spike earlier this month, those buying options have been paying well over the odds. Writing options here seems the no brainer. I liked the idea of selling premium with some long delta with a couple of different ideas leading into September, due to the pretty reliable seasonal tendency. That's worked out pretty well, but who's game to write unhedged on the call side in this market?

Not this little black duck!

Runaway gold markets don't happen that often, but the bulls can go berserk if *something* happens. Nevertheless, there is a bit of short gamma fun to be had here in this market... just cap the risk IMO.

The Big O(s)

2009-09-28T15:50:00.003+01:00

There was an interesting article floating around a few of the trading message boards on Friday regarding OptionsXpress, Optionetics and George Fontanills.

I wanted to post the excepts then but couldn't find the source. Thanks to Don Fishback who has posted on the same subject with correct attribution, I am doing likewise today at last...

From Barrons:

There is reason to be skeptical about claims made by Optionetics, a trading-seminar outfit that optionsXpress hopes will lure customers.

A cracking read for seminar skeptics.

Homeless

2009-09-28T15:21:00.002+01:00

As of the weekend I am officially homeless as we start our exodus to a new country. I am still in the UK for a few weeks, but staying with family. My trading desk is now a makeshift affair consisting of... well, never mind, use your imagination. lol

Posting may be sporadic, but I'll try and keep the blog idling along so-as not to lose my three readers completely.

An interesting point about trading businesses is that I am able to keep my trading business ticking along during this period of travelling... not exactly in a hammock at the beach in the Bahamas like some of the seminar clowns like to portray, but nevertheless possible to do so on the move.

A nice advantage.

I must admit that I prefer my own cave to trade from however. I'm looking forward to settling down again.

More on That Oil Option Skew

2009-09-22T15:46:00.004+01:00

The Bloomberg oils option article I mentioned yesterday has caught a couple of other options bloggers attention today.

Don Fishback has a closer look at the directional implications of the downside skew and concludes it doesn't really mean a lot.

Adam Warner makes substantively the same points as me and takes a swing at Bloomberg clichés, but is also skeptical of any directional signals.

Looks as if Bloomberg has been pwned by the blogosphere on this occasion.

Bloomberg Option Blooper

2009-09-21T19:05:00.004+01:00

There are no end of erroneous statements regarding options that appear in financial publications. Today I'm going to pick on an article in Bloomberg, because I just happened to do something I don't often do... and that is read Bloomberg. (Nothing worse about Bloomberg than other Wall Street Cheerleaders, I don't often read much of any of them).

This is what they had to say:

Oil Options Hit Highs as Verleger Predicts 44% Plunge

Sept. 21 (Bloomberg) -- Oil traders are paying more than ever in the options market to protect against a plunge in crude prices.

Oil options are something I follow pretty closely, so fearing a volatility spike that I had missed, I immediately pulled up $OVX (The VIX of oil options)

Hmmmmm IV near recent lows, no spike there. What could our B'berg author be on about here. Reading further:

The gap between prices of options betting on a decline and those that would profit from a rise in oil widened to a record 10 percentage points, according to five years of data compiled by Banc of America Securities-Merrill Lynch...

...Options granting the right to sell, or put, oil in December below current prices have a so-called implied volatility of 54.3 percent, compared with 43.3 percent for the equivalent options to buy, or call, data from the New York Mercantile Exchange show.

What's this? The arbitrage opportunity of the century? As I pulled up the option chain for December crude, I was multitasking and transferring every cent of spare cash in my trading account for mountains of reversal margin. Alas, I was disappointed as both ATM calls and puts were priced equally in terms of volatility.

What the f*** were they on about?

The subtle clue is what I have retrospectively bolded in the above quote. The author was comparing the IV of WOTM puts to WOTM calls. This is nothing more than a downside price skew. Skew is common in all sorts of markets; in fact it would be a little unusual for a market not to have some degree of skew to one side or another.

It's true that event sensitive commodities usually have skew to the upside and therefore skew to the downside in oil is noteworthy. The hypothesis that oil probably will experience some downside pressure is a fair one. But I wish they would call a spade a spade rather than dishing out erroneous bullshit on on options like this article has. Options are confusing enough for the neophyte, without inaccuracies from supposedly authoritative sources.

Give yourself an uppercut Bloomberg.

Options Spuikers Under The Spotlight

2009-09-18T01:53:00.002+01:00

Choice Magazine which is a consumer magazine down in Australia has done a bit of a spiel on options trading seminars, featuring "The Big O" and a local spruiker. Read the article here.

They took quite an even handed approach, but there are some interesting quotes:

One company, Optionetics, says if you don’t make 300% on your tuition fee in six months you’ll get your money back. Another, Traders Circle, recently said at a free seminar that if you start with just $4000, its options “mentoring program”, “recipe for success” and trading recommendations will teach you how to earn $1000 per month for the rest of your life.

I suppose enough has been said around the traps about Optionetics refund policy, but Traders Circle claiming 25% per month? For life? Hmmmmmm. Excuse me a second while burst out laughing.

We attended free seminars and spoke to other experts to find out if options are really the best way to profit from volatile market conditions. We found options to be highly speculative, with a very real chance you’ll lose everything you invest. We also uncovered some dubious get-rich-quick claims that downplay these risks.

The bit in blue might not be necessarily true, but Choice probably couldn't help arriving at that conclusion from what was presented. Re the green bit - Indeed.

We contacted Traders Circle to confirm what we’d heard at their free seminars. They clarified that profits are before costs described in the company's financial services guide including trading fees (up to $82.50 per trade), education fees ($7000-$13,000) and monthly subscriptions ($349), and before losses from unsuccessful trades.

Holy Shit!!

While the risks of options trading are described and the company (Optionetics) proposes to teach people how to set predetermined entry and exit points for trades as a way to cut their losses when markets move the wrong way, there’s far less focus on the losses that customers must also be experiencing.

We’re not the only ones sceptical about the potential profit claims. “While it may be possible for such returns to be achieved, it would only result from adopting risky strategies,” says the SDIA’s Doug Clark. “The risk of loss from trading in options can be substantial. In all investments, high returns usually mean high risk. A good options adviser is invaluable to help you understand the market and give suitable advice.”

Rod Peters of ABN AMRO Morgans uses options for private clients, but mainly for capital preservation and to earn an additional income, rather than to speculate on big profits. He says 1.5% profit per month, or even double digit figures in a year, would be “a phenomenal return” from options, even for someone prepared to accept some investment risk. “I don’t believe the higher returns being quoted by these options education companies are sustainable,” he says. “Any astute investor would realise that to achieve those returns you need to get lucky, take extreme risks, or both.”

Good comments.

My biggest eye rolling moments come from the "it only takes 20 minutes a day" assertions. Here's what one client had to say:

"I attended an options seminar in 2002 and, while I thoroughly enjoyed the program and felt I learnt a lot, I believe that the instructors give a false impression in relation to both the amount of time and effort required to trade properly. It was stated during the seminar that, provided we put alerts and stops on our buys, we would need to spend no more than 20 minutes per day to trade successfully. However, I do not believe this to be true and feel, particularly if you are working in a full time position, that it is simply not possible to monitor your trades effectively enough to be successful." Fran

Lastly, something anyone that's been around options longer than 5 minutes knows about these seminars:

"The biggest problem I've found with a lot of these training companies that offer 'free' seminars is that the courses they spruik are expensive (probably to cover the HUGE of marketing that they must incur) and the content of the free seminar is purely a marketing vehicle to build hype for the product." - Paul

It not a bad article and a good read. It bags out these companies with reasonably accurate information, but unfortunately perpetuates a few of the pernicious myths about options trading if someone was seriously considering going about it the right way. Lots of good quotes to pull out of it too.

Read.

PutCall Ratio - A Blunt Tool

2009-09-16T18:38:00.006+01:00

This is a bit of an update to the Put Call Ratio post of 26th August where I thought it could be signaling a toppy market. This is what I wrote.

The interesting thing for me is that the 20DMA of the equity only put/call ratio is now at its lowest level in the three years of the plot. That in and of itself probably means zip in the predictive sense, but if one wanted to make a case for a pause/consolidation/retracement in the indices sometime very soon, this indicator certainly would add some weight to that hypothesis.

Lots of bears are talking another major down leg, and generally I'm still a bear too, but I doubt we'll see too much downside in the medium term. But I'm making the case for a short term top somewhere around about here.

I'm claiming a minor hit with that guess. We did get a short retracement soon after that post... of course dip buyers were all over it like a rash and the bulls have pushed us to new highs.
However, that put/call ratio is still down at those extreme lows:

It's still raining greenbacks dropped from Uncle Ben's Helicopter, so there is nothing to stop this market continuing upwards. We're in pollyanna mode here, ignoring all the shithouse news coming from the real economy and pumping the "positives".

Maybe the recession IS over. I'll let time decide whether that's true, but we still have this extreme P/C reading. Tops are notoriously harder to pick with leading indicators than bottoms, and they're hard enough, but Holy mother of Mary we have to see some sort of retracement soon...

...don't we?

The truth is that these leading indicators are blunt tools, they need a bit of time to be right... just like a bear I guess. :)

On The Lack of Posts

2009-09-16T15:36:00.002+01:00

Your humble options blogger is moving far far away from his present location and will be travelling a bit for a while, so with organizing things, postings will be lean and sporadic.

But stay tuned.

PutCall Ratio Divinations

2009-08-26T14:28:00.005+01:00

The put/call ratio: Is it it predictive or reactive? Maybe a bit of both, just as I think VIX is. But like VIX and volatility in general, it tends to be mean reverting. Extreme readings don't often last a hell of a long time and are often the harbinger of a reversal - or at least a consolidation or retracement in the prevailing trend.

For the medium term view, and the P/C being a very volatile figure, I like the 20DMA of the equity only put/call ratio to find extreme readings.

Here is the last three years of this figure in green, plotted against the SP500:

A close examination highlights the inverse correlation.

The interesting thing for me is that the 20DMA of the equity only put/call ratio is now at its lowest level in the three years of the plot. That in and of itself probably means zip in the predictive sense, but if one wanted to make a case for a pause/consolidation/retracement in the indices sometime very soon, this indicator certainly would add some weight to that hypothesis.

Lots of bears are talking another major down leg, and generally I'm still a bear too, but I doubt we'll see too much downside in the medium term. But I'm making the case for a short term top somewhere around about here.

Some nice sideways action would do my spirit (and my index position) the world of good.

Futures Options - Part 3

2009-08-24T16:43:00.003+01:00

Judging by my site stats since starting on futures options, it doesn't seem like there is a lot of interest in them. That's a bit of a shame in my opinion, because there are some great opportunities to trade in the futures/commodities markets.

While there is nothing at all wrong with stock options and I will continue to trade them, commodity options can be far more suitable for some investors/traders, particularly if you like writing options.

The seasonal tendencies in commodity markets offer some unique opportunities, not just for speculating on direction via direct futures and/or long options and option spreads, but I think the most reliably profitable trades are the so-called "non-seasonal" option write as described in Stuart Johnston's "Trading Options to Win".

This is basically writing options on the opposite side of a seasonal tendency, or even just a seasonal non-tendency. This is a trade that has history and statistics on it's side and with discipline, is an excellent way to trade.

One of these to follow in the near future that I have alludes to already on the blog, is the seasonal bull in gold which begins around the 9th of Sept and continues to the first week in October.

I'll wrap up this "difference between stock and futures options" theme with a couple more points and then it's DYOR.

Tick Size

Each commodity future has its own minimum tick size that will relates to the price per bushel/tonne/bale/whatever and they are all different. As an example, the grain complex is quotes in cents per bushel (contract size is 5,000 bushels) with a minimum tick size of 1/4 of a cent. This means each cent movement on a contact of , say corn, is worth $50.00, while the minimum tick size is $12.50.

One would think the options would be quoted the same way. Nope. Grain options have a minimum tick size of 1/8 of a cent, not 1/4 cent. No big deal, but something to be aware of and something to research at the relevant exchange's site before trading them.

Margin

If you like writing options, you can leave Reg T behind with futures option. Futures options margins are calculated using a ludicrously complex algorithm called SPAN, which is short for

Standard Portfolio ANalysis of Risk and better known to stock option traders as portfolio margin.

As a general guide, short option premiums on ATM or OTM options will generally be less than their corresponding futures margins, which is quite generous.

There's enough there for folks to be aware that there are significant differences between stock and futures options and my best advice is to aways refer to the exchanges website to be sure of contract specs and expiry.

Futures Options - Part 2

2009-08-20T14:00:00.002+01:00

This is Part 2 of our look at futures options.

Contract Size.

Whereas a stock option is a right to buy or sell a parcel of a certain number of shares, a futures option is the right to buy or sell a futures contract. This is quite easy then, one option = one future. As a futures contract it is the right to buy or sell another derivative contract, this explains some of the various nuances of futures option.

Expiry

Stock options all typically expire on the same day in the monthly cycle. In the US, this is the third Friday of the month and all stock options are on a certain expiry cycle as per THIS LINK. It's all pretty easy to work out once you know how it works.

Futures options are different. While the US stock index options expire on the same day as stock options, commodity futures options all have there own expiration nuances that can take some time to get used to. Many commodity options actually expire the month before the contract month. For example, The December 2009 cocoa future expires on the 15th Dec, but the December 2009 cocoa option expires on the 6th November. The reason for this in this particular contract is that the option expires before the first notice day, where holders of futures contracts are required to notify their intentions for delivery of the physical commodity (Speculative traders will have exited this contract before then).

Every futures option is different and the exchanges website should be consulted as to the exact expiry of the option concerned. For a handy 2009 expiration guide for futures and their options, have a look here at Daniels Trading have put together.

Exercise

This is another nuance which is different for each commodity.

A stock option relates to the physical delivery of a parcel of shares. When you exercise or are assigned, you deliver or accept delivery of the number of shares in question.

As stated above, a futures option is an option on a futures contract. That is where the certainty ends.

Firstly there are regular expiry contracts and then there are serial expiry contracts. A regular exiry is an option whose expiry correlates to the futures expiry (even if it expires the month before). An example is the cocoa option mentioned above; the December option correlates to the December future, both are Z expiry.

However, futures options may have expiries between futures contract months. For example, if you look at our cocoa options example, there are options which are V (October) and X (November) expiry that do not have their own futures expiry. These are called serial expiry options. These are options on the Z (December) contract.

Confused?

It doesn't stop there. In some commodity options, the regular and serial expiry options may be settled in different ways. In some cash settled futures, the regular expiry options are settled in cash, whereas the serial options are settled with the futures contract.

The key is to always refer to the exchanges website to make sure of the expiry date and the settlement terms.

Enough for now, stay tuned for part 3

Future Options - A Bit Different

2009-08-19T18:39:00.004+01:00

With Liberty trading Group running all over the shop promoting the writing of commodity futures options, I thought it would be a good time to highlight some of the differences between futures options and stock options.

This first post is on pricing.

Anyone who looks at payoff diagrams will notice a slight difference in how futures options are priced. The most obvious diagram to look at is a straight out ATM long call and the corresponding long put.

Supposing you have two instruments with all things being identical, i.e. all inputs into the model are the same, but one is a futures option and the other a stock option. You will notice that stock option calls are more expensive than the futures option call. Likewise, the stock option puts will be cheaper than the futures option puts.

Also, if exactly at the money, the futures options call and put prices will be virtually identical.

Furthermore, again if exactly at the money, you will notice that stock option calls will have a delta of greater than 0.5, with the negative delta of puts less than 0.5 (the absolute values of both should add up to 1), whereas the futures option will be very much closer to, if not exactly 0.5 each.

The reason for this is the cost of carry priced into the options. Stock options make the assumption that someone is holding stock and is entitled to be paid carrying costs in lieu of risk free interest, whereas a futures option is an option on another derivative contract. This means that carrying costs priced into futures options are negligible.

There are a few other differences which I'll be going over ion the next few days - stay tuned

Stocks Good, Options Bad

2009-08-18T03:01:00.003+01:00

How many times have you heard someone pontificate on the subject of "stocks are good, options (or futures) are bad with the contention that:

Options (futures) are a zero sum game, for you to win, someone has to lose. They do not create any net wealth.
Stocks are a positive sum game. When you buy shares you are assisting the company to raise capital to build infrastructure, employ people and create value and wealth.

Anyone who's been around markets longer than 3 days will have heard this, or some variation of it It's a very persuasive argument used by many civic minded folk to avoid derivatives as they must be the spawn of Satan, stocks are virtuous. There is only one problem with this argument.

It's bullshit!

If one buys stock on the open market, not one dram, not one iota, not a jot of that capital goes to the company in question at all. While it's true that stock and bond markets are mechanisms for companies to raise capital, the vast majority of investors probably never contribute to this process at all. Or if so, it is a pittance.

Why? Companies only raise money through the issuance of NEW shares or bonds. Unless participating in an IPO or bond offering, the company will never see a cent of your money.

These are a miniscule proportion of transactions, with the overwhelming majority of transaction being the exchange of existing shares between specialists, marketmakers, institutions, traders and investors. The actual company whose shares we are trading is outside this loop, apart from you actually removing capital from the company if they pay you a dividend.

That means that for the most part, share trading is also a zero sum game (actually negative sum because of tranaction costs), capital profits come as opportunity cost for the seller.

The wealth creation bit is performed by the company itself, not the owner of shares purchased second hand on an exchange.

Ergo, the trading of options (or futures) or shares are equal in virtue, none have any moral advantage over the other.

Synthetic Equivalence - What It Ain't.

2009-08-17T20:00:00.005+01:00

I've posted a bit on synthetic equivalence a few time in recent months, both here on the blog and on some message boards. Some people have a few trouble with this concept even when proven mathematically, so thought I would talk a bit on what it is and what it isn't.

For what it is, I'll leave the explaining to Charles Cottle, from The Hidden Reality:

There is the raw (actual)position consisting of the exact options that contribute to an overall strategy. For every raw position there are a number of alternative positions called synthetic positions (synthetics). A synthetic position has the same risk profile as its raw position and achieves the same objectives.

What that means is that the risk profile of an option strategy can be duplicated via different combinations of options and/or stocks. A few examples:

A covered call is a synthetic naked short put
A married put is a synthetic long call
A collar is a synthetic vertical spread

There are dozens of combinations that can duplicate the risk profile of different combinations.

The problem seems to be that some people feel that the positions must me identical in every respect to be synthetically equivalent. The most common objection is that of different capital/margin requirements. - that if one position needed more money to trade than the other, they can't be synthetically equivalent.

One fellow didn't feel that a long call/short corresponding put wasn't synthetically equivalent to long stock, because he could get the option combo on margin, whereas the stock required the full investment of the value of the stock. That *may* be true for some traders. But it is certainly not true for others due to different margin rules, haircuts or whatever.

The logical extrapolation of that logic would be that stock bought on margin is not the same as stock bought for cash.

In any case, capital/margin requirements are not relevant to synthetic equivalence. What is relevant, it the risk profile... the payoff diagram adjusted for cost of carry and dividends if necessary.

Capital/Margin is not considered when looking at synthetic equivalence.

How to Trade VIX

2009-08-17T19:36:00.002+01:00

There seems to be more and more interest in directly trading the VIX lately. I've not succumbed myself, but of course am a keen observer. The most sensible commentary does not come from Bloomberg or the clowns on CNBC, but from Adam Warner's Daily Options Report and Bill Luby's VIX And More. These guys do actually trade, contrary to what on suspects with the MSM pundits.

There is a good post today over at VIX and More on how to trade the VIX - worth a gander if interested. How to Trade the VIX.

A CNN Bearfest

2009-08-13T19:45:00.002+01:00

In the absence of anything worthwhile to say today, how about this bearfest from a couple of weeks ago.

Niall Ferguson, Nouriel Roubini and Mortimer Zuckerman revive the Apocalypse.

Gold Doldrums

2009-08-12T15:04:00.003+01:00

A few days ago I highlighted the rising implied volatility of gold options. That seems to have been the high for gold IV for now, as IVs have settled back to the high teens.

Nothing more than a short term IV spike which has been fairly typical.

Meanwhile, realized volatility remains low, much lower than IV but as discussed before, there are good reasons for this.

Gold seems to be rooted in the doldrums, but there is always that September seasonal tendency to look out for and then there is the inflation hedge argument... QE and all that.

My purely baseless guess is that gold dribbles along for a while; until it doesn't.

Credit Spread Myths

2009-08-11T12:42:00.002+01:00

So a few posts back I started on a bit of a rant on the BS being passed off as information on credit spreads and gave up about half way through. As the fashion for option bloggers is to do the odd video these days, I decided to finish the job in a video.

I've picked on the same article, because it encaspulates most of the nonsense out there in just two or three paragraphs and a few bullet points. I don't have anything to sell, so no need to be wary about any marketing at the end.

Options Profits Reportage

2009-08-10T11:51:00.003+01:00

Those folks that have been around options for any length of time, might have noticed the way in which options newsletters and course sellers report profits (but never losses :))from options.

The first trend goes something like:

...top-performing 2009 trades scored 844%, 416%, 390% and 227%

Is it possible? Of course it is. It might be true, it might accurately reflect the facts, but is it appropriate to report it in this way?

Firstly, big wins are nice, but on their own say nothing unless in context with a string of trades taken by the trader. The bottom line is that the sum of winning trades must exceed the sum of losing trades for there to be a profit at the end of the year. This is what's never reported on. This big outlier wins are important of course, but what is more important is the number and scale of losses in comparison. Mathematical expectancy is what's important.

The second point is the capital allocation to these option trades. If a stock trader allocates a $10,000 position size to each trade, how much capital should the trader allocate to a long option trade?

Anybody that buys $10,000 worth of options in place of $10,000 worth of stocks, probably should be committed; particularly if they are out of the money option punts.

Obviously if the trader uses some sort of position sizing algorithm based on capital at risk (fixed fractional or similar), the capital used in each trade will be commensurately smaller with the option trade.

Put these two points together and those huge percentage wins take on an entirely different perspective. The question should be: What is the return on capital with reasonable risk control in place?

But that doesn't make for good advertising copy does it?

The second trend is the practice of annualizing profits. For example:

Net Premium: 2.70
Net Return: 3.8%
Annualised Return: 87%

If the trader could guarantee similar net returns with no gaps and possibility of losses, it might be a valid way of reporting losses.

But this is the real world, traders must deal with the reality of losing sometimes. Once again sums of wins versus sums of losses (AKA expectancy) applies. How many times does the trader win 3.8% and how many and what percentage losses does the trader suffer over the course of the year.

And on the niggly point of losses, should they also be reported on an annualized basis? That wouldn't make good advertising copy would it.

Imagine a 7% loss on a 4 week covered call annualized. That doesn't look so good. :(

The only thing important to any trader, whether trading options, stocks, or tiddly-winks, is the bottom line at the end of the year. That is, the return on the entire account. We trade options to hopefully improve that return over other methods of trading and investing, but there there is more to it than many vendors let on and more to it that what is reported in some blogs and options advertising.

I'm probably "preaching to the converted" mostly; obvious stuff to anyone who trades options seriously. It's still worth putting out there once in a while for new people coming in to Option Land to consider.

Volatility? What Volatility?

2009-08-07T16:45:00.007+01:00

In option land, volatility has a specific mathematical definition and is used in the various pricing models (Black Scholes et al). That definition is as follows - the annualized standard deviation of logarithmic daily change in price. I have highlighted "daily" because that's what it measures, the daily change of price.

Option volatility takes no account of the trendiness of the underlying instrument however.

Let say instrument (a) moves 1% up and 1% down alternately for 20 days in a row, but instrument (b) moves up 0.5% every day for twenty days. Instrument (a) finishes very close to where it started, hardly any nett movement at all, yet (b) is up over 10% higher after the 20 days.

According to the option volatility formula, the volatility measured over this time frame is much higher for (a) than for (b).

But depending on your precise option positions (b) could probably *feel* a lot more volatile than (a).

This is the feeling some may be having at the moment if trading delta neutral strategies on index options (or just about any stock option actually). Realized volatilities have been trending down for months, with 20 day historical volatility sitting at just ~16% as I write. Yet anyone with short gamma wing spreads or (gulp) short strangles is going to be *feeling* like they are in a volatile market.

Well actually, we are, if you use a different measure of volatility.

Plain old standard deviation, measures the deviation from the mean (and as used in Bollinger Bands) over a set time frame tells a different story. While it has nothing to do with option pricing, it does show how much price is moving around or a longer period of time.

Check out the chart below (NB Stockcharts doesn't have HV as used in option pricing models, but Average True Range is used a proxy, as it also measures the daily range): Over the last three months 30 day ATR has gradually been trending downwards, mimicking HV as use in OPMs, yet 30 day standard deviation is at a high over the time period.

This is telling us what we already know, that the Indices have been flying in one direction. Volatility over a period of time IS in fact high as measured by standard deviation, even though volatility of daily changes has been declining.

It's another dimension to volatility that we retail traders probably need to throw into the mix when making volatility projections. For us, option volatility is important for pricing, but may not tell the whole story when analysing potential trades.

Covered Calls - Naked Puts Redux

2009-08-06T15:49:00.003+01:00

About a month ago, I was opining opining that though covered calls and naked puts are synthetic equivalents, there may be valid structural or psychological reasons why a trader might use one over the other.

It might not surprise many that I am impressed by my own profundity in that discussion ;). *Some* other arguments on the merits of one over the other leave me underwhelmed however, most particularly when those arguments are chockers full of non-sequiturs, half truths and plain old BS. These of course are all over the place in Option Land, but I'll pick on a recent article published by an option book vendor.

In the article, the author recognised the synthetic equivalency of covered calls and naked puts (rare), but argues the superiority of CCs based on a load of old cobblers, to wit:

Here are the reasons I prefer covered call writing to naked put selling:

1- Many brokerages want the assurance to know that you have the ability to purchase the shares you are obligated to buy when selling the put. Therefore, they will require you to have an adequate amount of cash in your account to cover such an event. You will then have sold a cash-secured put and set aside the same amount of cash as the CC seller.

I don't see this as a disadvantage at all if the goal is conservative premium collection. As the author acknowledges, capital usage is the same. Therefore, there is no valid reason on this point to prefer covered calls.

2- The seller of a covered call captures all dividends distributed by the underlying corporation, the put seller does not. We’re not talking about a huge windfall here, but the cash is better in our pockets than someone else’s.

Just plain incorrect. Option pricing takes into account any pending dividend and option pricing cum-dividend and ex-dividend account for them. If you have a covered call position, the call premium will be cheaper to the tune of the dividend amount. You get the dividend via the stock, but you lose it via less call premium. I have an article on the effects of dividends for further information.

3- Selling covered calls allows the investor more flexibility. The most profit a naked put seller can generate is the premium on the option sale. A covered call writer can profit from the option premium PLUS additional share appreciation if an out-of-the-money strike is sold. That choice is available to the covered call writer but not to the naked put seller.

There is still no difference in payoff. If an OTM call is written, the *corresponding* ITM naked put can also be written, again with the same payoff diagram as the OTM covered call. Synthetic equivalence is maintained no matter what the strike price.

4- Early assignment is not an issue for CC writers because the option premium is not affected and possible additional upside appreciation is incorporated into your profits if an O-T-M strike was sold. For naked put sellers, early assignment could be a disaster. Imagine a stock gapping down, and the stock “put” to us at the $30 strike. The stock is plummeting and heading for the teens! The put seller wants to sell the stock before it loses more ground but perhaps the shares haven’t even hit his account yet. He may have to wait until the next day to sell the shares. One way of getting around this issue is to sell the shares short (selling before actually owning them). The problem with this solution is that average... investors will have a difficult time getting “shorting privileges” from their brokerage firm and may lack the sophistication necessary to manage such situations. Besides, who needs the headaches?

There are a couple of points here:

a) It's true that the naked put might be assigned early if there is zero extrinsic value, however the short put will have a delta of +1, or very close to it, and will be trading like the stock anyway. This will put the trader in a position of a substantial open loss for sure, but the author neglects to inform the reader that the covered call will be in the identical position of a large open loss. Once again, the positions will be the same.

b) The suggested response of shorting stock is incorrect for the stated goal of exiting the position, as you don't know if and/or when you will be assigned. You may just be flipping your deltas and have an open synthetic short call. That's not what the author intended. There is no law that says you have to hold the put till expiry or assignment. The best response if you want to exit the trade before possibly being assigned is just buy back the written put.

5- Those interested in option investing in tax sheltered accounts, will have an easier time establishing such accounts using covered call writing than any other form of options trading.

This isn't my field, but I am led to believe that cash covered naked puts are permissable in such tax sheltered accounts.

If people really want to trade covered calls over naked puts, fine, there may be valid reasons as I stated in my earlier article. No skin off my nose, but let's not justify it with misinformation and bullshit.

Gold Volatility Popping

2009-08-05T12:03:00.006+01:00

Gold volatilities, along with vols in just about everything have been in a steady tankage since the near Apocalypse in the latter part of 2008.

The following image is of 63 day, 20 day and 6 day historical volatilitities on GLD the gold ETF; the varying lookback periods serve as a look at the structural volatility of gold. The general level of HVs have come from ~50-60% down to sub 20%, effectively reducing by two thirds. It does look like HVs are bottoming out however.

This level of HV is not unusual, having visited these levels twice before since the inception of this ETF in late 2004, the observation at those points was that vols stayed pretty low for months before eventually popping.

So does this mean gold stays quiet for a few months? Maybe not. Two things to note going forward.

1/ The seasonal tendency of gold shows that September is traditionally when gold starts flying, because of jewellery demand at this time of year,apparantly. This chart from www.spectrumcommodities.com

Important thing about seasonals; it's a historical *tendency*. It doesn't mean gold WILL run higher during September.

2/ Implied volatilities are popping, with IV a full ~50% higher than the 30 day HV plotted on the following graph.

So are option traders anticipating an increase in realized volatility? Well, IVs have consistently overestimated realized volatility; there's good reason for this with the ever present chance of Gold bugs going ape shit over one or another threat to world stability.

But an IV pop is what it is, it doesn't necessarily protend anything, as we can see from recent history, but reason to sit up and take notice. Perhaps the pop in the underlying a couple of days ago is responsible, perhaps gold bugs are about to party... again.

I think it's interesting juncture. I don't have a position in gold at the moment, but this looks an interesting time to watch more closely.

Conciousness vs Heuristics

2009-07-31T18:10:00.002+01:00

In my previous post I discussed the competency scale used across a number of fields. The Ducster took issue with the term "unconscious".

From sigmaoptions, this post appeared discussing mental competencies. In a first part response, I’ll look at the Greeks component. In the second, I’ll consider the actual neurological pathways involved, and why in this example, unconscious is a misnomer.

While knowing what the term is getting at, I agree it is a misnomer; in the field of options trading anyway.

He suggests that the advanced options trader is in fact utilizing some form of heuristic reasoning rather than being "unconcious". That's probably more accurate, but it sure messes with the poetry of the "unconscious incompetent => unconscious competent" hypothesis.

So how to rejig it to incorporate "heuristic"? I can't think of anything that flows and describes the progression of competency nearly so well.

Suggestions welcome.

Options and the Unconscious Competent

2009-07-30T11:59:00.004+01:00

In other technical fields, I often heard of experts speak of the phases of skill progression from novice to expert, invariably stated as having four phases as below:

Unconscious Incompetent
Conscious Incompetent
Conscious Competent
Unconscious Competent

It's a fancy way of saying that you progress from an idiot, to knowing what you're doing without thinking. The unconscious competent is that individual that acts and reacts from second nature without having to think first. A kung fu master has hundreds of complicated techniques as his disposal that are second nature, due to thousands upon thousands of hours of practice. A master tradesman can be thinking about the hot looking woman that just walked past while he works; he is creating his work without thinking about it.

(N.B. I use the male gender generically and of course include females in this discussion)

Options trading is of course no different and it is the aim of any non-delusional individual to progress to the Unconscious Competent stage; just knowing what to do at any point, quickly, without an over reliance on software, calculators and suchlike.

The unconscious competent can have been in such a state for so long, that he no longer realizes what knowledge he is actually using.

An illustration of this point came up on a discussion forum recently. The question was asked, can you be successful without regard to the Greeks? Various points of view were put forth, but the one that interested me was from an ex-institutional trader with decades of high level experience. He thought that Greeks were not necessary for simple directional strategies.

I questioned whether he in fact had a mental map of option pricing that was so ingrained, that perhaps had a "picture" of the Greeks that he used without thinking about it, even with simple strategies. At first he didn't think so, but later reversed that opinion and agreed.

That man is an unconscious competent. Options trading is just second nature, to the point that he doesn't even have to think about it. This is the state all will aspire to and achieve given the correct knowledge/education. This is actually easier said than done as there is soooo much erroneous information and truly worthless (and very bloomin' expensive) options education programs out there.

Getting to the Conscious Competent stage for a retail trader is harder than many imagine, that is, getting the correct grounding in options theory and pricing. So many crash and burn from being taught BS.

Every options education program, whether in book form or CD/Internet course needs to be marketed in order to attract clients; and the trainers will require remuneration for their efforts.

But how does the options neophyte sort the good from the bad and the truly ugly?

Even good programs will indulge in a certain level of hype. This is the reality of marketing, "warts and all" reality just won't sell well. But on the other hand, what seems to good to be true, probably is. This is the sort of thing I have bagging out recently, the total BS claims and totally erroneous and inaccurate, even mischievously outrageous claims.

I guess it boils down to avoiding the worst of the hype and being somewhat skeptical, perhaps even cynical when evaluating a potential information vendor.

Be careful out there. Marketers are master psychologists (unconscious competents) and work on your base emotions rather than your intellect. Some of the worst programs are the most absolutely taleted marketers, because they appeal to those most powerful of financial market emotions, fear and greed.

American vs Euro Double Take

2009-07-25T23:56:00.004+01:00

As I trawl around the options universe I see many statements from the erroneous to the downright dishonest. Occasionally there are statements from ersatz options "experts" that even make me do a double take, so stunning are they in their cretinous ignorance.

Behold the latest example, from someone selling information, producing videos etc:

American vs. European style options:

American style options such as OEX or SPY can be traded anytime. European style options can not be closed until their expiration date. I prefer to trade American style options since I can buy and sell them out when I want.

LMAO

Of course European style options can be traded into and out of, anytime, just as American style options can. Jesus! We ALL know that one don't we? (For the newbies reading this, American or European style refers to when options can be exercised, not whether they can be closed out or not.)

Further down the page, we are served up this little beauty, in big bold type:

Turn $1000 into $124,000 in One Year!!!

Where do I sign?

VIX Options Weirdness

2009-07-23T21:03:00.002+01:00

I don't trade VIX options, but I've shown some pretty wacky disparities between call and put IVs. I thought there had to be an explanation, because it just wasn't credible that such huge differences weren't arbed away.

Dean Mouscher has the answer in a 16 minute video on the subject.

If you are trading these, or might at some point in the future, this is a must view.

Probability is Probably Improbable

2009-07-20T19:05:00.003+01:00

The Ducster has brought an interesting theme in the whole probability/expectancy conundrum that has been bouncing around the blogosphere of late:

Probabilities, or frequencies that are calculated via Black-Scholes, Binominal Tree or even the more esoteric methodology of GARCH, all essentially utilise a Gaussian distribution of stock prices in their volatility calculations.

This as the old saw notes, generally works well, until it doesn’t. <<Read>>

Essentially, probabilities are calculated by one or another model using a sample past data. This is a problem. As we know, in real life, stock market distributions do not really adhere to distribution assumptions of the various models - Black Scholes, Binomial Tree et al. There are models that are allegedly better, but not in common use. More particularly, the data sample used, or even volatility projections implied by option price may bear no relation to future volatility as it is realized. Also, statistical probabilities change as events unfold.

Two days can change the statistical landscape the trader has used to place a trade altogether.

The whole problem with using a model is... well, it's just a model...

...and models fail.

So when option traders make assumptions about probabilities and take risks based on them, it is really treading on thin ice. It's a guess. It may be an educated guess, but a guess nonetheless.

Ergo, option traders should question how probable the probability is.

"It'll never happen", happens with enough frequency to weed out model arrogance.

Survivors of 8 sigma events are those wise enough to mistrust "probabilities" and religiously cover their ass.

Probability Is Only Part Of The Puzzle

2009-07-19T20:07:00.005+01:00

Over the last couple of weeks I've been concentrating on option trading myths and nonsense, in particular the myth of 90% of options expiring worthless, but only alluding to the second part of the puzzle. That second part of the puzzle is mathematical expectancy.

As Dean from www.masteroptions.com pointed out in a comment on my previous post:

The debate over what percentage of options expires out of the money misses the point. Even if it were true that 90% of options expired worthless it would mean nothing. There's also the matter of how much you make on your winners vs how much you lose on your losers.

Never a truer word said. Probability of win is irrelevant on its own.

The expectancy equation has two parts, 1) probability of win and 2) win size vs loss size. One way of expressing this mathematically is with this equation:

Expectancy = ((1 + reward/risk ratio) * win/loss ratio)-1

One way to have a look at this principle in practice is to wander down to the casino and play a little roulette. It is a wonderful way to understand this principle, because at the roulette wheel, it does not matter one iota with what probability we play, the negative expectancy cannot be overcome. On a 00 wheel the negative expectancy is -5.26%.

We can create a ~90% probability, but that won't help us a jot. A chip placed on 34 numbers gives us a ~89.5% probability of winning paying 36/34, but it's still a losing strategy in the long run. Let's look at the maths:

Expectancy = ((1 + reward/risk ratio) * win/loss ratio)-1

= ((1 +2/34) *34/38)-1

= -0.0526

= -5.26%

Likewise, an option strategy with a theoretically 90% probability, whether an actual statistical probability, or an erroneous probability, doesn't make the trader profitable in the long run. We are all aware of the snatching pennies from in front of a steam roller analogy.

If you make $1,000 90% of the time and lose $10,000 10% of the time, you're down a hole. In fact, you lose $1,000 every ten trades on average.

F### that!

High probability trades are nice in theory, but a trader still has to develop a positive mathematical edge. So our "90% of options expire worthless so sell options" pseudo-gurus actually make two major misrepresentations; that 90% options expire worthless and that this automatically confers profitability.

Mathematics outs in the end.

90% Of Options Expire Worthless

2009-07-15T12:17:00.003+01:00

In the previous post, the quoted "guru" stated unequivocally that 90% of options expire worthless, wit the implication that option sellers have an edge over buyers... actually it's often explicitly stated.

According to the Chicago Board Options Exchange, typically only about 30% of options expire worthless in each monthly cycle. Only about 10% of options are exercised during each monthly cycle, usually in the final week before expiration. In fact, over 60% of all options are traded out in the marketplace. This means that buyers sell their options in the market, and writers buy their positions back to close.

So we see that the "90% of options expire worthless myth" is... a myth.

The fact it that there is no inherent edge in buying or selling options at point of inception, if they are correctly priced. It can be determined in retrospect, but the problem is that we cannot see into the future. There is no way of knowing whether the option premium is cheap or expensive, because we don't know what the underlying is going to do.

I like being nett short premium, because I am better at managing those positions for more consistent profit, but it does not mean being nett long premium is wrong. Each has it's own set of management implications.

Horses for courses.

Credit Spread Nonsense

2009-07-13T11:11:00.003+01:00

In keeping with my current fetish for trying to bust a few nonsensical myths and mistruths with premium collection strategies, I guess I've turned my attention to credit spreads.

Look! Credit spreads are a good strategy, one good strategy, one of any number of good strategies. I use them when I think they are the right strategy to use. What makes me lose the will to live is the bullshit that emanates from ersatz experts and course spruikers.

N.B. I have nothing against education courses at all. There are a few good ones I'll never criticize, but they are outnumbered by some truly odious and dangerous programs inflicted on innocent neophyte option traders... usually at vast expense.

To subject (sent via email so unable to attribute) of my ire today, which resulted in a distinctly forehead shaped dent in my desk, behold:

The beauty of option trading is that it opens up a lot of alternative ways building wealth from the stock market. Recent events have shown that the "buy-and-hold" approach to stock trading carries substantial risk. With a volatile market, a safe "in-and-out" approach is much more desirable. Of all the option trading strategies available, trading credit spreads is by far the safest and simplest method. It has a risk profile significantly lower than stock trading, and it offers much better profit than any type of stock trading strategy around.

Selling credit spreads takes advantage of the fact that the value of any option declines as the expiry date of the option approaches. It does this particularly fast during the last 30 days of the life of the option. It has been said that 90% of option buyers lose their money. This means that those who sold the options to those unfortunate buyers win 90% of the time!

What are the advantages of credit spread trading?
It is short term - trades are typically less than 30 days in duration, and take advantage of short term trends in the market;
It is low risk - trades have a better than 90% of success - always! You know exactly what the risk, return and profit will be before you enter a trade - there is no guess work.
Profit is up front - a trader gets his profit immediately, and only needs to protect that profit for a short period;
Market fluctuations are mostly irrelevant. The market can continue its trend, stagnate, or even turn against you to a certain extent, and your profit is completely safe and untouchable.
Simple technical analysis - other options trading strategies (and stock trading) require intense fundamental and technical analysis, significant understanding of the market, and the ability to "beat the news". Selling Credit spreads needs a very simple trend analysis procedure, which should not take longer than 10 minutes a day, and the ability to plan for upcoming events such as earnings reports.
Time spent in monitoring the trade is very low;
Profits range between 5% and 20% per month, depending on how actively the spreads are traded. Compounded, this leads to significant growth in a profile. Starting with $1,000 and gaining a steady but sure 15% per month, you can get your first million dollars in four years, without deductions for ulcer treatment.
What do you need in order to start building wealth by selling credit spreads?
you need an account with an options trading broker such as Thinkorswim or OptionsXpress.
you need a minimum balance of $1,000, in order to cover margin requirements for selling credit spreads.
you need to be able to identify a trend in the market and in your chosen stock.
you need to be able to look ahead for predictable events such as earning reports and dividend payments.
you need about 15 minutes per week.
...and that's it!
You do not need nuclear physics degree in fundamental and technical analysis; you do not need to spend hours pouring over graphs and indicators; you do not need to go bald, get an ulcer or a heart condition; and you definitely do not need to pander to your obsessive compulsion to constantly monitor your trade, making fiddly adjustments on the way!

Selling credit spreads is an excellent method for those who are committed to a safe, steady approach to building wealth.

I sell credit spreads every month, and even when a very few trades have gone against me, I still build an average 15-20% growth on my portfolio each month.

Hallelujah! The Holy Grail found! Gold, Frankincense and Myrrh for all! If your still with me, indulge me in a point by point fisking:

The beauty of option trading is that it opens up a lot of alternative ways building wealth from the stock market.

A good start for the writer here, this is exactly the reason we option traders trade options rather than the underlying stocks. Unfortunately, it's all downhill from here.

Recent events have shown that the "buy-and-hold" approach to stock trading carries substantial risk.

Well, yes, but wait for the rest.

With a volatile market, a safe "in-and-out" approach is much more desirable.

Why is it more desirable? It might be for the author and it might be for me, but it might be the antithesis of what is desirable for somebody else, depending on innumerable factors.

Of all the option trading strategies available, trading credit spreads is by far the safest and simplest method.

How so? Simplest? So a two legged strategy is simpler than a simple bought option? Safest? How does he/she quantify safe? Considering that one can put their entire capital at risk in one trade, with some probabilty of a maximum loss, I violently disagree. Most strategies are safe if used safely, i.e. with proper position sizing. All strategies, including credit spreads, are unsafe if used with too much size/leverage.

It has a risk profile significantly lower than stock trading, and it offers much better profit than any type of stock trading strategy around.

This is about the point where my forehead first hit my desk with some velocity. Without going into mathematics and payoff diagrams, this is a truly pukeworthy statement. Much better profit? Credit spreads offer a "different" risk/reward/probability profile which may be better in certain circumstances but not others. Stock going sideways? Sure, give me a credit spread or related strategy. Stock about to go to the moon? I'll take the stock, or perhaps some call options thanks.

Selling credit spreads takes advantage of the fact that the value of any option declines as the expiry date of the option approaches. It does this particularly fast during the last 30 days of the life of the option.

This person has obviously never heard of delta/gamma. True, extrinsic value, in simplistic terms, declines, but what about intrinsic value? I want to ask this person if he/she thinks the value of the put option he/she just sold is going to be worth less if $10 in the money at expiry.

It has been said that 90% of option buyers lose their money. This means that those who sold the options to those unfortunate buyers win 90% of the time!

Just disingenuous bullshit. Even the standard myth only says 80%. The truth is somewhat different and more complex. For another post maybe.

It is short term - trades are typically less than 30 days in duration, and take advantage of short term trends in the market;

Yes short term, but the preceding statement says this person is trading OTM credit spreads. If I want to trade short term trends, I'll pick an entirely different strategy. OTM Credit spreads are best for non-trends or slow trends. If you're trying to trade a trend and still want a vertical spread, go an ATM debit spread.

It is low risk - trades have a better than 90% of success - always! You know exactly what the risk, return and profit will be before you enter a trade - there is no guess work.

Well I don't know about low risk, there is a higher probability, but also a very low reward compared to the outright risk. Again that's OK, if it suits your view. But a credit spread constructed with 90% theoretical probability is going to be extremely skinny on the nett credit. As far as "always", a truly risible statement.

Profit is up front - a trader gets his profit immediately, and only needs to protect that profit for a short period;

Oh brother!! The old credit is better than a debit fallacy. I wonder if this person ever tried to spend that up front profit? I wonder if he/she ever looked at their margin statement. I think these are best constructed as credit spread, but for completely different reasons than the up front credit. The credit is *irrelevent*. It is the positive theta one is trying to trade here while hoping not to get crunched by the other greeks. Positive theta, AKA premium collection, can still be acheived with an initial debit.

Market fluctuations are mostly irrelevant. The market can continue its trend, stagnate, or even turn against you to a certain extent, and your profit is completely safe and untouchable.

This one is kind of half true. Provided that the underlying doesn't close ITM on the sold option, you keep the credit. In the intervening period however, you can be deep in a hole if the stock is moving against you. The profit is most certainly not safe as you are then in a position of hope. An exit or adjustment is going to cost.

Simple technical analysis - other options trading strategies (and stock trading) require intense fundamental and technical analysis, significant understanding of the market, and the ability to "beat the news". Selling Credit spreads needs a very simple trend analysis procedure, which should not take longer than 10 minutes a day, and the ability to plan for upcoming events such as earnings reports.

What can I say.... this is just nonsense. A simple approach may work, indeed it does. But a simple laissez faire TA approach is not going to give you 90% probability spreads.

Profits range between 5% and 20% per month, depending on how actively the spreads are traded. Compounded, this leads to significant growth in a profile. Starting with $1,000 and gaining a steady but sure 15% per month, you can get your first million dollars in four years, without deductions for ulcer treatment.

[sigh] The BS just doesn't stop! I'm weary, I've had enough of this. Maybe I'll continue this once I've recovered from concussion

The Second Apocalypse?

2009-07-10T13:21:00.003+01:00

There is an email doing the rounds in London at the moment purportedly written by the MD of a major bank. Excerpts were posted on The Financial Times Aphaville blog - Here is copy and paste of the excerpts... very bearish:

US Housing

It lead us into this recession & it will likely lead us out. -This asset class is the collateral spine of household & bank B/S. It remains a sine qua non for the mkt. Unfortunately, foreclosure filings are +18% yoy (May), the mort delinquiency rate (9.12%) is a record, prime defaults have just doubled (yoy) to 2.9%, new and existing home sales are still barely off their Jan lows (you’d need to see a 50% increase from here to be consistent with flat gdp), unsold inventory is still at 10.2 mths (even without shadow inventory from banks & Securitised Mort Trusts), 30% of mort are in negative equity & rising, -18.1% hse prices is still ugly….
US Consumer

Too much debt, not enough credit. -Declines in the housing & equity mkts have removed c$14tr from his net worth (Fed) at a time when he’s 3x the leverage of 20 yrs ago & carrying $13.5tr of debt. That process of de-leveraging is just starting. Delinquencies on Home Loans just hit 3.5% (ABI), a number that will grow in tandem with unemployment & US Personal bankruptcies (ABI) were +35% last seen. Look at the recent & salutary examples of the banks and Japan’s lost decade to remind us just how painful & prolonged the de-leveraging process can be.

The savings rate just hit 6.9%. It has reverted to 10% in prev deep downturns. That cld be exacerbated by a baby boomer generation who in previous recessions cld get credit & had a higher propensity to spend (in their 30’s) but who now can’t get credit & have a greater propensity to save (as they’re now in their 50’s).

The latest non-farm number (-472,000) wasn’t just worse than expectations, but was worse than the very worst print seen in either of the ‘80-’82, ‘90-’01 or ‘01-’02 downturns. Initial Jobless yesterday were better, but Continuing claims were worse (& a record high). Unemployment (beware the lagging mantra) is relevant because this is a credit related crisis & unemployment’s continued rise to & thru 10% (The Congressional budget is based on 8.1% ‘09) will generate more delinquencies & foreclosures. Moreover, the “leading” indicator components of the non-farm report-Hours worked (still at a record low & with a 70% correlation to GDP) & Temporary Hires (-37/-) are still showing falling leaves rather than green shoots.

Credit cards (the lender of last resort) are seeing record charge offs (Moody’s:-10.6% vs 9.9% in Apr) & cc outstandings are falling at a 20% annualised rate with consumer credit contracting by over $50bn since Lehman hit the tape. Remember, the consumer is just starting, not just ending his de-leveraging process.
US Insiders

A vote of No confidence. -51% of CEO’s (Business Roundtable) expect lower capex (the inventory replenishment is now a given for the mkt) & 49% expect lower payrolls going fwd. -Directors sold $2.9bn of stock in June (Trimtabs). The Sell/Buy ratio is a monster 10x, so the green shoot callers might be selling it, but the Corp insiders aren’t buying it.
US Dividends

70% of US equity rtns since 1900 (LBS) have been generated by dividends. -In Q2 just 233 S&P names raised their divi (a record low) & 250 names actually cut (2nd worst ever reading).
US Valuation

Valuations are not at a level that discounts any ongoing negative news. -Mkt bottomed (666) on 11.7x. The ave of of the last 11 bear mkts (where over 70% have seen a lower bottom) has been 9.9x (Haver) & there’s nothing ave about this recession. -Going all the way back to 1929 (NDR) and we find that PE multiple expansion has averaged 10% in the first 3 mths & 22% in the first 6 mths of recovery. We just clocked up 40%! With the “P” already there we need the “e” to catch up real fast to validate this rally.
US Technicals & Volume

Better to wear out than rust up? -Dow has broken its 8300 Head & Shoulders neckline support & 200 day move ave (FTSE has broken its 4295 Triple Top neckline, 200 day & failed to breach its channel top). Dow theory (DJT has failed to validate the main index highs) is also firmly in the bear camp. S&P has been clinging on by its fingernails but the breach below its 200 @ 887 & a subsequent fall below major support @ 875 wld frighten lots of rabbits.

-Ave daily vol has contracted by 30% on the S&P & c 50% on the Dow over the last 3 mths (Trimtabs). -Bear mkt bottoms (19 going back to the war) have typically been associated with steady eddy rallies on good vol (Hussman). The 4 episodes that were the exception & saw rel light vol also only rallied modestly. We’ve just belted the biggest rally since the Depression on thin vol with just slightly less depressing news….which reminds me of the Sage of Omaha’s axiom that “you can’t make a baby in a day by making 9 women pregnant”.

Light trading vol (compounded by higher vol on recent down days vs lower vol on recent up days), and a diminished response to “positive” news imply that we don’t need to see strong selling pressure to roll us over some more. Just buyer’s fatigue. And we need to beat (a 62% beat rate in Q1) not just meet consensus eps forecasts for Q2.
US Issuance

Today’s problem or tomorrow’s promise? May clocked up $64bn & June was similar. The prev record issuance was $38bn. There have only been 12 mths since ‘98 that Corp issuance has exceeded $30bn & the ave rtn of the S&P over the nxt qtr was btwn -4% to -7% (Trimtabs)
US Quotes (recent)

Moody’s:-”US housing wont hit bottom until 2010″.

Hayashi (Jpn Economy Minister) “The US economy has yet to hit bottom”.

S&P:- “CMBS credit deterioration is just beginning” ($400bn of commercial property re-sets to y/e). I think this space is armed & dangerous.

IMF:-”The retrenching of the US consumer is a huge adjustment that the whole global economy is going to have to absorb”.

Buffett (who’s a bull remember) “I had a cataract op on my eye recently & I still can’t see any green shoots”.

Moody’s:-”US housing wont hit bottom until 2010″. Hayashi (Jpn Economy Minister) “The US economy has yet to hit bottom”. S&P:- “CMBS credit deterioration is just beginning” ($400bn of commercial property re-sets to y/e). I think this space is armed & dangerous. IMF:-”The retrenching of the US consumer is a huge adjustment that the whole global economy is going to have to absorb”. Buffett (who’s a bull remember) “I had a cataract op on my eye recently & I still can’t see any green shoots”.
US/China

Our knight in shining armour. But… -The US is 25% of global gdp & China is 8%. -6% Chinese gdp grth (which we’re all now excited about) is actually still consistent with an ongoing global recession. -For every 1% that the US consumer shrinks, the Chinese consumer needs to expand by 6%. -Jpn shipments to China dropped -29.7% in May (-25.9% in Apr). -1/3rd of China’s gdp are exports (47% for Asia)….& those mkts are still contracting. People are talking up de-coupling again, despite the fact that that particular chocolate teapot got melted before.
And finally
California, Russian banks, CMBS, Sovereign risk (Baltic states), Swine Flu….

Naked Puts Ad Nauseam

2009-07-06T14:54:00.004+01:00

OK, clearly I have a bee in my bonnet about naked puts at the moment. As we have discussed in the preceding days, a naked put is equivalent to a covered call, vis a vis, a covered call is a synthetic naked put.

The main problem seems to be with the thinking, the psychology around this strategy. Over the weekend, once again I listened to trader friends referring with great fear and loathing about the risks of naked puts, yet waxing lyrical about the virtue covered calls.

It makes me want to smash my head against a wall... actually I wanted to smash their head against a wall, but I would have possibly lost their friendship in doing so. So I imbibed in that favourite English pastime of drinking to excess instead. A tactic which ensures a change of topic to fast cars, football and loose women. Genius... but I digress.

So now I'm back into the mire of markets, economies and managing option positions, I'll preach into the electronic ether, instead of at my friends.

Dean posted a comment below which referred to a thread on the Motley Fool's discussion board. In it was what I thought was a very useful thinking exercise when considering naked puts (and by synthetic implication, covered calls) and once again, it involves synthetics. (Hat Tip BeautifulPlumage)

We know that we can create a synthetic long stock position with options, by buying a call and selling a corresponding put, so we can look at any stock position as having a long call and short put embedded within it.

We can then analyze the naked put option as a long stock position with the short call stripped out leaving only the short put. A covered call can be looked at precisely the same way, as you have long stock with the long call component stripped out, buy writing (selling) the call leaving only the short put, albeit synthetically.

Why would an investor/trader do this?

By implication, the investor is dodging the cost of buying unlimited upside (the call option premium) and electing to collect the premium available in the short put. He is implying that he doesn't believe the stock is going to appreciate in value more than the strike price, plus what the put option premium is going to deliver in the time to expiry. If he does believe the stock is going higher than that point, he is short changing himself.

He also (by implication) doesn't believe the stock is going to fall by more than the strike price plus premium collected, otherwise just stay out, or use a different strategy. However if the stock does fall past this point, at least the loss is less than long stock.

It is a bet that the stock price is going to stay in a range.

Obviously, the put premium has to be adequate recompense for the risk taken, measured against the probability of such moves occurring in the time frame.

There is no new information there and this is all pretty obvious stuff for those with a good grasp of synthetics, but I thought it was an interesting way of looking at these two strategies, and a good way for people whose thinking has been confused by definitive statements that aren't consistent with reality.

Once again, there are various reasons people want to trade the naked put and it's synthetic equivalent (covered call) which may or may not be optimum for their purposes and there are other strategies from which to select. I'm not promoting this as a good or a bad thing. It's just an exercise in understanding.

The VXV

2009-07-03T12:54:00.002+01:00

It's the CBOE S&P 500 Three-Month Volatility Index. It is from the same family as VIX, but whereas the VIX looks at the implied volatilities of SP500 options of 30 days duration (according to a formula), the VXV looks at the three month picture.

Bill Luby of Vix & More has a good article in Barrons that details how we can use it:

As a result of its elevated profile, the VIX is now followed by a wider variety of investors than at any time in the history of the index. But while the VIX is an important tool, investors -- including those who do not trade options -- would be well-served to look past the VIX for a more nuanced understanding of volatility and its implications for their portfolios.

A case in point is the little-known VXV, whose formal name is the CBOE S&P 500 Three-Month Volatility Index. The VIX calculates implied volatility in S&P 500 index options for merely the next 30 days, but VXV uses a 93-day time window. The different time horizons have some important implications.

You can read the rest of the article HERE.

Where For Art Thou, GS?

2009-07-03T12:12:00.004+01:00

"They" let me down yesterday. I will certainly have to brush up on my soothsaying skills I guess.

The employment numbers and the market reaction (a 2 standard deviation move down) must raise the specter of a continuation of the bear market. Most of the credible experts (those that predicted the whole mess in the first place) are incredulous at the up move since March and believe the market should be much lower.

I agree. So when where will the market be manipulated next?

For me, I couldn't give a crap, just don't get there too fast so I can hedge my deltas. VIX ticked up a couple of %, a solid, but not fearful move, so I'm not worried about fast markets... yet, but I don't think we've seen the last of fast down markets.

Disclaimer: I'm delta neutral on the indices.

I'm Buying

2009-07-02T11:46:00.004+01:00

OK now that I'm in full conspiracy theory mode, my prediction for today is that GS and MS will have a busy day in the SP pits.

A comment in response to Marketwatch's pre-non farm payrolls numbers:

MarketWatch - why do you pass on this gobbledegook? You guys know as well as all of us that the U.S. government "statistics" are about as dependable as a 2 dollar watch.

...and there are dozens along the same lines.

The payroll numbers will be dreadful, but folk will suspect the government is lying and things are actually much worse (Noooo - who'd believe that?). Folks will realise the bobbleheads optimism is totally misplaced and flog all their stocks the market will open sharply down.

GS & MS will start buying with their ears pinned back for some mysterious account, the market will finish green, Goldilocks will make another cameo appearance, folks will be conned into believing all is well and a return to the upward grind will ensue.

Disclaimer: I'm short gamma on the indices with a little upside skew.

OK I've let my cynicism out for a run, back to normal programming shortly.

Update: As expected, the #s were woeful, now all I need for soothsayer status is for the SP500 to be green by day's end.

Market Manipulated! Levin Lets The Cat Out Of The Bag!

2009-07-01T20:51:00.003+01:00

Original Content Sigma Options

++++++++++

Via ZeroHedge, here is a jawdropping video where Larry Levin let's the cat out of the bag about gu'mint manipulation.

"Larry Levin is a professional futures trader. He has been in and around the S&P 500 futures pit at the largest futures exchange in the world; the Chicago Mercantile Exchange (CME), for almost 20 years.
Larry has been trading his own account or company's proprietary accounts since 1993, trading an average of 2500-3000 E-mini S&P futures contracts a day."

The meaty bit starts at about 2 minutes in.

Covered Calls and Naked Puts - Same Only Different

2009-07-01T17:49:00.004+01:00

Original Content Sigma Options

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We all know that naked puts and covered calls are synthetically equivalent... well I hope we all know by now, and we know that a buy write IS a covered call.

My thesis today is that they all may be quite different, not in risk profile, but in the psychology these strategies are a subject of.

Firstly the difference between a covered call and a buy write. Of course there is no official difference, it's long stock and short a call no matter which name you use, but I think there is a difference of inception, the nomenclature different according to the goal of the trader. I think of a buy write as when a stock is bought with the call written at the same time. A covered call I think of as a call written over stock already owned, perhaps for some considerable length of time.

A buy write is entered as a trade to collect the premium (Here I am speaking of general practice, not my practice) and the buy writer is hoping that the stock goes up and is called away. Of course a written put can be used instead, but there are a few reason why the trader doesn't use the naked put. He may have done one of "those" courses. He may not know about synthetic equivalency. His muppet of a broker may not allow him to trade naked puts. This is the sort of trader that scans for high IVs looking for maximum premium (for better or for worse), but he usually doesn't want to keep the stock.

The covered call trader on the other hand, already owns the stock. He probably doesn't want his stock called away, particularly if he has a low cost base and doesn't want a capital gains tax event. As such he is probably writing the call to partially hedge and/or derive some extra income from the premium. His stock is going sideways or perhaps on what he hopes is a short term decline. If the call goes in the money, he is more likely to trade out of the call rather than have his stock assigned.

Please note that these are personal definitions and may not reflects other's thinking.

The naked put trader generally has one of two goals. He either want to just collect premium, so is like our buy writer, or he is writing puts he hopes will end up in the money and wants to be assigned the stock. This second type of naked put trader is more akin, but slightly different to our covered call trader. He is used the puts as part of an overall investment strategy and not really a trader.

All of the above traders may select different strikes and expiries depending on what his ultimate goal is.

So yes, all have the identical payoff diagram when the strike price and expiry are the same, but there are different reasons and psychology that dictate different approaches within the same group of strategies.

Put Spreads - How to Blow Yourself Up In One Easy Lesson

2009-06-30T11:32:00.003+01:00

Original Content Sigma Options

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My last few posts have been concentrating of naked puts, the main point I've been trying to get across is that they no more risky than anything else, less so, in fact. But we've seen that they can indeed be a weapon of mass wealth destruction if the trader uses inappropriate levels of leverage.

See:

Naked Puts - Myths & Truths

Naked Puts - An Addendum

Naked Puts - A Horror Story

A suggestion that came up as a safer alternative for a straight out premium collection trade is the bull put spread. In principle, I agreed with the suggestion, but with a few caveats.

Proper money management/position sizing is used.
Reward versus risk is commensurate with the probability of win/loss.
Be careful of correlation with multiple positions.

Even though the bull put spread is perceived as a safer strategy than naked puts, it is not necessarily so, if our old friend leverage is used inappropriately. I would argue that bull put spreads may even be more dangerous than naked puts, depending on the margin requirements of individual jurisdictions and brokerages.

There was an option "education" firm (and I use that term very loosely) in Australia promoting bull put spreads as a panacea for wealth building. The chap even gave it a new name... his name - The ######### Strategy (I have no wish to publicize this rubbish) - how's that for marketing nonsense?

I don't have a challenge with bull puts, 'cept that they aren't appropriate at all times. To borrow a point from Ecclesiastes 3, there is a time for every strategy. The most odious feature of our ersatz options guru is the money management and position sizing algorithm whereby most, if not all of the trader's capital is put at risk in the market. This is spread across four or more positions, but the dearth of tradeable options on the Australian market means there is a very high degree of correlation in optionable stocks.

Every boat rises with the tide, as neophyte bull put traders thought that the Holy Grail had been found at last. That is until the arrival of last year's bear market. Those slow to react, in denial or too green to know what to do next were completely wiped out.

Once again, the fault is not the strategy, the fault is leverage... and fighting the tape.

Naked Puts - A Horror Story

2009-06-29T15:19:00.004+01:00

Original Content Sigma Options

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My last couple of posts have been concentrating on removing some of the misconceptions and erroneous assertations regarding the risk of naked puts. I hope I have been carefull enought to stress that you can crank up your risk to unreasonable levels with naked puts. (the same is true of many derivatives).

To illustrate this point, I'm using an example from 2005, because it involved someone I knew.

Background: I had posted up a chart of Elan (ELN:NYSE) in February 2006, on a trading forum I frequent. The stock had been going sideways for two or three months and was trading at ~$27.00. I wanted to get a sense of what folks thought was a good option strategy and generate a bit of options discussion.

Amongst the various replies, one chap said:

Trader: Sell 100 $22.50 puts for about $2000 credit.

Me: That's potentially 10,000 deltas if the stock gets smacked down hard and goes DITM.

Trader: It'll never get there.

The rest as they say, is history.

That's about $143,000 down the pan in one night.

It is important to note that the massive loss is nothing whatever to do with naked puts per se. An equivalent size covered call position would have similar losses, as would a CFD position of similar face value, even more in fact.

The loss was a conequence of "leverage".

I don't know whether the chap took the trade or not, but he was conspicious by his absense on that particular forum from then on. :-(

See:

Naked Puts - Myths and Truths

Naked Puts - An Addendum

2009-06-26T09:22:00.005+01:00

Firstly something a little off topic. It has come to my attention that some media sites have been linking my content onto their sites without my knowledge. I don't mind, it's a bit flattering to be honest, but they haven't extended me the courtesy of attributing the content with a link to this blog such as every blogger does when quoting content. I have no desire to start threatening legal action, so I'll just be putting an embedded link at the top of my posts from now on.

Original Content Sigma Options

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Yesterday I posted up some views on "Naked Puts - Myths And Truths", to which Mark Wolfinger from the excellent Options For Rookies blog, replied in the comments with some very good points I wanted to cover in a new post:

It's not 'being comfortable with the risks' that is the prime consideration.

What is important is for the trader to understand that there is an alternative strategy. Then the alternatives can be compared, and an intelligent choice can be made.

I strongly agree with Mark here. I find it a tad irksome the preponderance of options courses (that charge a rather enormous fee usually) that promote a single strategy as the key to options riches, be it covered calls (the usual) to put spreads, condors whatever. All are really great strategies for a particular market and/or volatility conditions. But no strategy is a catch all, to be applied without considering that there may be a better strategy for the moment.

I prefer selling put spreads. For me, the reduction in potential loss is well worth the reduced profit potential. That's my comfort zone, and each trader should find his/her own.

I have the same feeling in most cases, particularly with individual stocks. As I trade commodity options as well, for me it is not always so. But on stocks I just want to collect premium on, I don't want to be naked at all and also prefer a put spread.

I've moved into the camp that believes that naked put selling is ONLY for investors who want to buy shares as an investment. Traders would do better to use positions that are less risky. That's my opinion - it's not a demand that others agree.

Yes, as I mentioned in the previous post, you have to be prepared to end up with the stock if you trade naked puts. Unless you are happy to be holding the shares for some longer term objective, there are safer alternatives, as mentioned.

My only caveat comes with commodity options. Depending on the situation, based on seasonals, statistical studies, favourable IV etc., I'm quite happy to write naked for a straight out trade. Stuart Johnston covers this very well in his book Trading Options To Win. A great read if folks are into commodity options.

That in no way takes away the validity of Mark's comments however.

The fact that selling puts is less risky than buying stocks, doesn't mean it's a strategy without substantial risk.

Very true. However, if naked puts are risky, it then has to be accepted that long stock of equivalent position size is even more risky. The risk in both can be mitigated, save for humungous gaps.

Also as we know, there are legions of traders who do nothing but trade covered calls with no intention of holding stock long term, yet regard naked puts as the spawn of Satan. My objective was to skewer that misapprehension, arming folks with the knowledge to make more rational decisions. We know the covered call is synthetically equivalent to the naked put and once novice traders get their head around that, it presents them with one of two realisations

Folks happy with the risk of covered calls may feel equally happy to trade naked puts of the same face value.
Folks realise that covered calls are far more risky than the muppet that sold them a course has told them. I've even seen it claimed that covered calls carry zero risk. :-P

I hope I was careful enough to stress that one can increase their risk of ruin substantially with naked puts by trading too many contracts.

One more point. I don't dislike the idea of naked put selling. In fact, it's one of three strategies that I believe is suitable for rookies. But once the investor has some hands-on trading experience, I suggest moving on to the safer put spread.

I think that's good advice. The caveat being that people can still crash and burn with put spreads. There were a whole host of them I know of in Australia, the followers of one particular "guru" who promoted put spreads as a investing panacea, encouraging people to essentially have their entire capital as risk in correlated underlying stocks. The recent market crash machine gunned those poor folks to pieces.

Option people tend not to talk about money management very much (even specifically disregarded by some "gurus"), and this is paramount with any strategy, no matter how safe it is perceived to be. I think we option people make the mistake thinking that folks have some sort of position sizing algorithm in place. Often they don't and ruin may only be a market swing away with the majority of strategies if the leverage is cranked up enough.

My main point remains, don't be frightened of naked puts, they have their place in the option armoury.

There's plenty there for novices to think about, two slightly differing perspectives but not really that far away from each other.

Naked Puts - Myths and Truths

2009-06-25T11:41:00.003+01:00

Naked puts, no strategy is subject to more warnings from ersatz options experts and umm.... educators. Even some very good options people regurgitate some thoroughly dubious statements regarding naked puts. These generally encompass some sort of exhortation to not trade naked puts couched in such beauties as:

Naked puts are extremely risky.
Naked puts have unlimited risk.
Don't ever trade naked puts.
Naked puts cause diabetes and heart disease.

OK, I might have exaggerated a bit on the last point, but that is the general tone. All are nonsense without some qualifying conditions. Before I go on, I will point out that naked puts can be very risky if they are traded in a highly risky fashion, and we'll get into that in a moment.

Let's look at this with a bit of basic mathematics.

Naked Puts Are Extremely Risky

Believe it or not, naked puts are less risky than the underlying stock.

Let's take the example of Trader A buying 100 of XYZ common stock @ $50.00 (total outlay $5,000), and Trader B writing a contract of near month naked $50 puts and receiving $2.50 premium ($250 net premium received).

We are not looking at the upside on the stock here, although it should be recognised that the upside is capped at premium received for the option writer, we are looking specifically at risk alone.

At expiry, the put writer pockets the $250 premium no matter what happens to the stock. So if the stock closes @ $50 at option expiry, the option writer is $250 ahead of the stock owner whether assigned or not. Looks like the put writer is a winner in that instance.

What if the stock goes down though?

If the stock goes down, the put writer will likely be assigned and forced to pay $50 for stock that may be worth considerable less. Oh Yeah that's risky! But guess what, the stock buyer is holding stock, bought at $50, that is worth considerable less too. However the put writer has received $250 premium which he keeps, providing a cushion not available to the stock owner.

For example, if the stock is at $40 at option expiry, the stock owner will be down $1,000 at that point in time. Likewise, the put writer will have been assigned the stock @ $50, now worth $40; also a $1,000 loss. But the writer received that $250 premium which means the actual loss is $750.

What seems more risky to you $1,000 loss or $750 loss? The truth is that unless the stock is above $52.50 (in this example) the naked sold put will always be ahead of the stock.

There is another way of looking at this. Lots of folks trade naked puts all the time without ever giving it a second thought, they just trade them synthetically without ever realizing it. Enter the covered call. I have so many people argue with me that a covered call is not the same as a naked put, it's ridiculous. But the mathematics do not lie, a covered call IS a (synthetic) naked put.

Therefore it doesn't make a whole lot of sense to warn about naked puts when folks are completely at ease being long the stock, or long the stock and selling calls over it.

Most of the objections I encounter to this comparison do something like this = "Yeah but, my stop loss will take me out of the stock trade long before it gets to $40". Excuse me? Why is there this presumtion that because a person trades options, they do not have the brains to protect their capital? Options traders can use stop losses too, but it is more likely that they have another strategy in mind e.g. owning the shares or mitigation by adjustment or spreading off.

There are a couple of caveats to the above.

1/ All the above presumes an equal position size. In other words, if we're comparing naked puts to stock, it has to involve the same number, i.e. 100 stock compared to 1 standard option contract (or 1000 in some countries).

2/ Because of the possibilty of assignment, either at expiry or before, you need to have cash in your account to cover the purchase. Furthermore, you have to not mind winding up with the shares and/or have a plan on what to do once the shares are in your account.

There are some traders, through lack of caution or lack of knowledge, or perhaps just a bigger risk profile, who will write huge size out of the money puts, tens or perhaps hundred of contracts in order to collect premium with what they percieve as high probability. The problem is that a black swan event can (and eventually will) blow up those traders spectacularly.

It's proverbially snatching pennies in from in front of a steam roller. If the steam roller catches you, you get squashed. This may be what our option experts try to warn against, but it should be qualified with the actual maths.

Naked puts have unlimited risk

This is my favourite. The word "unlimited" means without limit, infinite. But do naked puts have unlimited risk?

What is the lowest a stock can go? It's zero isn't it? Can a stock go below zero? No, it can't. Therefore we know the maximum loss don't we?

Using the above example, our maximum loss on the naked put is $4,750, that is a $5,000 loss on the stock, less our $250 premium.

Is that unlimited? No!

Is risk unlimited? No! That's just silly.

A better term is "indeterminate risk".

Don't ever trade naked puts

OK don't, seriously! Not unless you are comfortable with the risk/reward profile. But don't not trade them because somebody regurgitated something he heard and never thought about. But if you trade covered calls, there is no reason why you shouldn't trade naked puts instead if you don't already own the stock.

And you shouldn't be afraid to trade them if you know, and are comfotable with the risks.

Of Tribes And Markets

2009-06-22T18:56:00.003+01:00

Many centuries ago, a great chief took his son on a journey across the great plain, over two great rivers, across the desert, through the forest whereupon he found a high place. He told his son to look as far as his eye could see and said:

Son, we are Carvetii, this is Carvetii country, and forever more the tribe was known as the Carvetii.

At about the same time another great chief took his son on a journey through a great forest, across two deserts, over a river and to the highest point for 100 miles. He told his son to look as far as his eye could see and said:

Son, we are Cantiaci, this is Cantiaci country, and forever more the tribe was known as the Cantiaci. (These are ancient Briton tribes in case you were wondering.)

Yet another great chief took his son on a great journey at the same time so many centuries ago. He led his son across three plains, across 14 deserts, paddled over 5 lakes, traversed 7 mountain ranges, through 3 forests, across another three deserts, another 2 rivers until he found a high place. He looked at his son and said:

Son, where the Fukawee, and forever more, that people were known as Fukawees.

Centuries later, I am wondering the same thing following the markets convolutions. VIX seems to be moribund, yet is higher than at most times before Sept 2008. Bubblevision boasts of green shoots and recessions ending, yet real world data still indicates death by a thousand cuts. Housing industry vested interests speak of a bottom, yet housing remains very expensive by any sensible vectors of value (here in the UK at least).

Worst of all, brokers shout BARGAIN BUY STOCKS from proverbial rooftops, yet reported earnings make them look expensive.

There is no doubt that the cash raining down in torrents from magical helicopters is having an effect; but where next?

The SP500 is rolling over and getting a bit of a shellacking today in particular. A simple profit taking retracement, or an end to a dead cat bounce? Will Armageddon part 2 start up after this intermission, or is it the next great bull run.

Doomberg reports that insiders are selling shares at the fastest pace in two years and the put/call ratio is signalling *sell*.

Look, all I want is to put on a nice delta neutral strategy with a nice wide profit zone and go and watch the tennis, supping Champagne, slurping strawberries and cream and watch Andy Murray disappoint the Brits again, as is the tradition. Alas, this market is making me nervous. I have no fear of adjusting, but being full of booze and around the corner at Wimbledon stadium, my mind wandering to fantasy as I watch the ladies play... or not, as the case may be, is just not conducive to high falutin option trading.

So I guess I'll stay home and watch it on TV...I can't get out of my driveway anyway now that The Championships have started anyway. It will have to be pizza and beer, rather than champagne, strawberries and cream.

Here Endeth The Hiatus

2009-06-01T16:05:00.002+01:00

I've had an extended break from blogging always promising myself to come back soon. Now is the time. I'm going to have a fiddle with my template and a perhaps a few trivial posts, then into it with some gusto.

Anyone who's followed me for a while will know that I was a bear... vindicated!

I'd like to say that I got rich out of it, alas, as I've also said before, extreme volatility is a bitch to trade. I had some great wins, but also some losses. What's new? Business as usual.

The cool thing is that even through some of the stormiest stock market action for years, option traders can still make a good living, while long only investors were taken to the wood shed. Though the ballsy ones who jumped on at the bottom might be feeling pretty chuffed.

Anyway, for better or for worse, I'm back.

More About Volatility

2008-05-07T16:53:00.005+01:00

In the previous article, I received a question with regards to comparing implied volatility (IV) and historical volatility, so I’ll talk a bit about that.

Firstly I want to concentrate on HV. As I’ve pointed out in previous articles, HV looks backwards. A period of time is selected, that is, the most recent x days of data is used to calculate the historical volatility mathematically as per my previous article on volatility.

This begs the question, how many days should we look back over: 10 days, 20 days, 30, 100, 250? The general rule of thumb is either 20 or 30 days, roughly one month. But depending on the look-back period, we can get vastly differing figures for HV.

Consider the following chart where 10, 20, 30 and 100 day HV is plotted: click to enlarge

This shows the vastly differing values that can be derived, depending on the look-back period.

And below, the IV mean compared against 30 day HV for the same chart:

The thing to remember here is that IV is trying to predict future realized volatility. As this chart is of near expiry IVs, it is trying to predict actual volatility about 20 – 30 days ahead, so to truly make a comparison; IV should be compared with HV about a month into the future.

Three things to note here:

1) The market does a reasonably good job of it at times, but drastically wrong at other times.

2) It is not possible to do in real time as we cannot see into the future.

3) Volatility is mean reverting; it tends to oscillate up and down around the mean.

We can use this information to make a “guess” as to what volatility (not direction) will do next. It is suggested in many texts to buy options when IVs are low and to sell options when IVs are high. It is also suggested that options are overpriced when IV is higher than HV, and under priced when IV is lower than HV.

That may be the case at times, but at other times it is absolutely false. It is then clear that assumptions such as these can get you into trouble if applied indiscriminately. But it is a good starting point; just don’t treat it as gospel.

How can the trader tell when options are overpriced or under priced? You can’t! You can only do it in retrospect.

However as traders, we get paid for taking risk. The options trader must make a volatility bet along with a bet on direction (or no direction). So if IVs are high, the question is whether the underlier is about to get very volatile for some reason, or whether option traders have just got a bit carried away and realized volatility does not increase, or falls; and visa-versa.

Implied Volatility

2008-05-05T19:56:00.006+01:00

We have now gone through the six inputs into the Black Scholes Option Pricing Model (as proxy for any model in use). The sixth input, volatility, is problematic as a forward guestimation of volatility is used, it is equivocal; different traders will have different ideas of what this input should be.

For instance, I may believe a particular option’s fair value is $2.65 using my own volatility projection, but when I go into the market it may be $3.75, for the sake of example. What is going on?

What is happening here is that the “market” believes that the future volatility of the underlier is going to be a lot more volatile than you do. How does the market do that? Simply by the bids and asks in the market depth and by arbitrage. Depending on your data supplier or broker, there may be a figure supplied called “Implied Volatility”.

This is worked out by algebra, using the first five unequivocal inputs into the option pricing model and the tradable price, which is also unequivocal at that point in time, to derive a volatility figure. So what we are saying here, is that the volatility “implied” by the option’s price is x; Hence “Implied Volatility”.

Let’s look at an example:

* The underlier (XYZ) is trading at 52.75 with no dividend payable.
* I’m looking the XYZ $55.00 call option, which expires in 63 days, which I can buy for $2.45.
* Risk free interest rates are 5%

By plugging those known values into our option pricing model, (in this case I’m using the Cox, Ross & Rubinstein Binomial Model) we can calculate an implied volatility of 36.7%.

So how does that help us?

Quite simply, it is from this figure that you can determine whether the option is fair value or not.

Often in various textbooks and spots around the Internet, the suggestion is to compare Implied Volatility (IV) to Historical Volatility (HV) to determine whether an option is over, or under priced. This is a gross oversimplification. Historical volatility should be studied to get an idea of the volatility characteristics of the underlier, but says very little about what volatility will be going forward.

Remember Implied Volatility looks forward, while Historical Volatility looks backward. For instance, IV can rise before an earnings announcement, sometimes quite dramatically, even though the underlying stock has become very non-volatile as the market waits for the announcement. The market is therefore making a judgment on the volatility once earnings are released. IV invariable drops equally dramatically once the earnings are actually released, as the market discounts the move from the announcement.

The history of Implied Volatility can be plotted on a chart, just like Historical Volatility, again to see the characteristics of IV and how it changes under various circumstances. There are various vendors of IV data, but there is a free source from www. cboe.com from where I sourced the following chart:

The IV plotted in the above is an average of near expiry, implied volatilities across several strikes, so the IV of the particular option you’re interested in may vary somewhat from what is represented here. It does however give the trader an idea of the ebb and flow of volatility over time. You can use this information to make volatility projections and to bet on future volatility fluctuations with a suitable strategy.

The standard wisdom is to buy low volatility and sell high volatility. While this may make sense on the face of it, it isn’t always the wisest thing to do, but more on that later.

Next - More On Volatility

VIX Doldrums

2008-05-02T18:48:00.005+01:00

A few thoughts on the situation on the VIX.

From VIX And More:

Dissecting views on VIX technical analysis

VIX Numbers and Overbought Signals

Ten Things Everyone Should Know About the VIX

And from The Daily Options Report:

On VIX @ < 20

Tommorow Cancelled

It certainly has gone a bit quiet and the market seems to be anticipating a repeat of last summer's relentless upward grind.

Sans the end of the world happening, I think that about sizes things up until next earnings season... unless of course the sky does fall down.

Volatility

2008-05-02T13:23:00.005+01:00

The sixth and final input into the Option Pricing Model is volatility.

It is my observation that there is often a bit of confusion about this term. If you listen to any of the financial media, volatility is only ever mentioned when the market is going down. To be sure, a 400-point down day on the Dow is a volatile move, but a 400-point up day is never described as volatile, yet it is equally so.

In the simplest terms, volatility is the relative rate at which the price of a security moves up and down. Market technicians have various methods of measuring volatility, using a variety of formulae, but our option pricing model requires a particular measure of volatility; the annualized standard deviation of logarithmic daily change in price.

Now that’s a mouthful, and most option traders view volatility in relative terms without understanding the calculation, but I think it helps to actually understand the mathematics behind it. We can do this with Excel or charting software, which I will give an example of, but let’s do it in English first

We start of by calculating for each day’s data, today’s closing price divided by yesterday’s closing price. This will return a number that is today’s price as a proportion of yesterday’s price. If there is no change, the number will be 1.0, if it is up 2% it will return 1.02, if it is down 5% it will return 0.95 and so on.

The next stage is to find the natural logarithm of the above. This is to reflect the lognormal distribution of stock market returns. Next, multiply this by 100 to express it as a percentage. We can plot this as a scatter chart, which will show the lognormal daily move as a percentage

The next step is to calculate the standard deviation of the above. Normally this is calculated over the last 20 or 30 days of data; it can be any length, but for this example we will use 20 days. This gives us the standard deviation of logarithmic daily change in price, which can be plotted on a chart to see changes in volatility as time goes by. However, Option Pricing Models require that volatility is expressed as an annualized percentage and we do this by multiplying by the square root of the total number of trading days in a year, which is the square root of 252.

This is now the finished volatility calculation, which is called “Historical” or “Statistical” volatility, plotted in the chart below”

This equation can be plotted in charting software to show current and past historical volatility. In Metastock or Amibroker language, (the two platforms I am familiar with) it can be plotted by using the following formula:

(StDev(log(C/Ref(C,-1)),20)*sqrt(252))*100

The above formula calculates historical volatility based on he last 20 days, the figure in red. Any look-back period can be used and some option traders use various length.

So now we can enter this volatility figure into our Option Pricing Model to get an accurate option price; or can we?

The historical volatility number, depending on the look-back period can vary enormously, and as the name implies, looks at past data, whereas what we really want to know as option traders is what volatility will be in the time left until the option expires. As this cannot be known, this forces the option trader to make a volatility forecast, or at least an idea of where volatility might be relative to the present in order to calculate his or her idea of fair value. This where historical volatility can be used as a tool, but the trader must look forward.

Often the market will disagree with you, which I will discuss in the next section.

Next - Implied Volatility

Effect Of Dividends Payable

2008-05-02T13:20:00.003+01:00

The fifth input into the Option Pricing Model is dividends. If the underlying pays no dividend, then there is no effect on option prices. However if the stock does have an upcoming cash dividend payable, it will have an effect on option prices. It is very important to be aware of this, as many a neophyte option trader has been caught out by thinking an arbitrage opportunity existed with mis-priced options, when in fact the pricing anomaly was due to an upcoming dividend; hence not an anomaly at all.

The reason for this is that option holders are not entitled to participate in cash dividends, so option prices must compensate.

It is a general rule of thumb that the underlying stock will drop by the dividend amount when the stock goes ex-dividend, all things being equal. As far as the stockholder is concerned, he/she ends up squits; what is lost on the stock, is gained in cash.

Option Pricing Formulae account for this by considering the move in the underlying due to going ex-dividend.

When the stock is cum-dividend, call option prices will be cheaper than they would be if there were no dividend payable, reverting to “no-dividend” pricing on the ex dividend date. This has the effect of shielding the call option holder from an unwarranted loss due to the drop in the underlying.

The reverse is true for put options. When the stock is cum-dividend, put prices will be more expensive than they would be if there were no dividend payable, reverting to “no-dividend” pricing on the ex dividend date. This has the effect of ensuring that the put holder doesn’t receive an unwarranted windfall profit.

In a Nutshell

When a dividend is payable:

Call option prices will be cheaper.
Put option prices will be more expensive.

Next - Volatility

Effect Of Interest Rates

2008-05-02T13:12:00.002+01:00

The fourth input into the Option Pricing Model is “risk free interest rate”.

Firstly, what are risk free interest rates? The risk free interest rate is the theoretical interest rate that would be returned on an investment completely free of risk, generally taken to be the yield on 3 month Treasury Bills.

At first glance it is a bit hard to imagine why this would affect option prices. However, it is in the presumption that one side of the trade may be holding stock for no possible return and that the stockholder is due a risk free return for having their capital tied up and not earning interest.

Firstly, let’s have a look at call options. As we know, call options give the owner of the option the right to buy the underlying stock at the strike price. And we know that the writer of the option is obligated to sell shares to the holder of the option at the strike price. The option-pricing model therefore assumes that the option writer is actually holding the stock to be able to sell it to the buyer, if the buyer exercises.

This means the stockholder is incurring carrying costs in the form of loss of risk free interest income on cash and is due some compensation in the option price. The option buyer is in effect, paying the option writer risk free interest rates, in advance, for the life of the option. The effect however, is incremental according to the moneyness of the option. The risk free rate is fully priced in for deep ITM call options, whereas it is not priced in at all in far OTM call options.

The fact that you are paying the risk free rate “up front” means that the longer to option expiry, the higher the interest rate component of the call option premium.

Of course it also means that higher risk free interest rates mean higher call option prices, all things being equal.

The effect is quite obvious on our risk graph of call options. Below is an image for comparison of the same option at differing risk free rates. Both graphs are of a $50 ATM call option with 145 days to expiry. To make the comparison visually obvious, I have used radically different risk free rates. It is most obvious in the deep ITM side of the graph, as marked. The top ATM call option at 1% has a premium of $3.85, whereas the bottom image at 12% has a premium of $4.95.

With put options the story is somewhat different. It is not the option writer who is presumed to be holding stock, as is with the case with call options; it is the option holder who is presumed to be holding the stock. The holder of a put option has the right to sell the underlying to the writer, so it is the put option holder who is compensated for loss of interest income on cash before putting to the option writer.

Therefore the rule of thumb for put options is that higher risk free rates mean cheaper put prices, all things being equal.

With put options it is not so graphically obvious, but we can see it in the option premium. Both graphs are of a $50 ATM put option with 145 days to expiry. The top ATM put option at 1% has a premium of $3.65, whereas the bottom image at 12% has a premium of $2.87.

It should be noted that the above only applies where there is real cost of carry considerations, i.e. when the stockholder is required to finance the stockholding with cash and/or interest paid on margin. With options on futures, the cost of carry is prices into the price of the futures contract; therefore risk free rates have no significant effect on option prices.

Time & Time Decay

2008-05-02T13:00:00.006+01:00

The third input into Option Pricing Models is time until expiry. The key to understanding this principle is understanding that the option buyer is paying the option writer to take on risk. The buyer has the right to transact shares, but the writer is obligated to transact shares if the buyer exercises that right.

The call writer stands to lose a substantial amount of money if the stock rises past the strike price. Likewise, the put writer can lose a substantial amount of money if the stock drops below the strike price.

The general principle is very similar to insurance premiums. The more insurance you buy in terms of time, the more expensive it is. So it is with options, the more time you buy, the more premium you pay.

On the option writer’s side of the equation, the more time the option writer sells, the higher the chance of the option moving ITM, therefore the more you get paid for taking on this higher risk.

Therefore the general rule of thumb is, all things being equal, more time equals higher option premium, less time means lower option premiums.

This has implications for option holders. Options are a depreciating asset, often described as like holding melting ice in your hand. As the life of an option is finite and fixed, the option loses time value the closer to expiry it gets. This is known as “time decay”.

The graph below is of a call option with 30 days until expiry plotted as the uppermost line in red, with the other colored lines at six-day intervals with the black line at expiry. This clearly shows the time decay in long options.

On the other hand, this is to the benefit of option writers, who in return for assuming the bulk of the risk, get to profit from time decay.

For options that are ATM, time decay accelerates as expiry approaches. Have a look at the graph below. It is a graph of the extrinsic value only of the call option in the above graph.

It is very clear from this graph the accelerating nature of time decay. At 30 days from expiry, the ATM option has $295 (in this example) of extrinsic value, yet according to our model, at 6 days from expiry, the option still retains $130, with approximately $90 at 3 days.

It is often graphically represented as follows with time elapsed on the x axis:

But what not many option resourses will tell you though, is that this is a representation of time decay ATM or quite close to it. As the option gets further ITM or OTM, this characteristic changes. Time decay, depending how far away from the money it is, will actually decelerate into expiry, as shown in the graph below:

This is useful knowledge when considering strategies where deep ITM or deep OTM options are used.

Next - Effect Of Interest Rates

More On Options Pricing

2008-05-02T12:50:00.007+01:00

In an earlier section, I outlined the six inputs into the option pricing model that are required to calculate an option premium:

1/ The price of the underlying
2/ The strike price
3/ The time till expiry
4/ Risk free interest rates
5/ Dividends, if any
6/ Volatility

Note that “premium” is not a term I’ve used before, but is interchangeable with “price”.

In this section I want to cover in more detail the first two inputs, the price of the underlying asset and strike price as it is important how these to relate to each other.

Both of these inputs are unequivocally known at any point is time, the strike price of course is constant, whereas the price of the underlying will fluctuate from day to day and minute to minute.

It is in the relationship of these two inputs that we derive 3 new terms, which I will introduce now:

Intrinsic value
Extrinsic value
Moneyness

Moneyness is further divided into three terms of relevance:

At the money
In the money
Out of the money

Let’s cover the moneyness terminology first. An option is said to be “at the money” (ATM), if the underlying stock is trading at or near the option strike price. This is fairly self-explanatory and is the same for both call options and put options. For example, if we have a $50 call or put option where the underlying is trading at $50.00, that option is trading ATM.

A call option where the underlying is trading higher than the strike price is said to be “in the money” (ITM). For example, if we have a $20 call option where the underlying is trading at $22.30, that call option is ITM.

It therefore stands to reason that a call option where the underlying is trading lower than the strike price is said to be “out of the money” (OTM). For example, if we have a $30 call option where the underlying is trading at $27.90, that call option is OTM.

Put options on the other hand are precisely the opposite to call options.

A put option where the underlying is trading lower than the strike price is said to be “in the money” (ITM). For example, if we have a $50 put option where the underlying is trading at $46.70, that put option is ITM.

It therefore stands to reason that a put option where the underlying is trading higher than the strike price is said to be “out of the money” (OTM). For example, if we have an $80 put option where the underlying is trading at $83.90, that call option is OTM.

In practice, the nearest strike to the price of the underlying is often referred to as ATM, even though it may be a little bit ITM or OTM.

Intrinsic and Extrinsic Value

If an option is ITM, is has intrinsic value. Why? Let’s look at an example. Let’s say we own a $50 call option with the underlying trading a $55.00. That option is $5.00 ITM.

A $50 call option gives you the right to buy those shares at $50, so if you exercise the option you can buy the stock for $50 and immediately sell for $55.00, a $5.00 profit. Therefore that option is worth at least $5.00.

So “intrinsic value” is simply the amount by which an option is ITM.

Remember that put options are the reverse. A put option is ITM if the underlying is trading below the exercise price, because you can exercise to sell stock and buy back with an immediate profit.

ATM and OTM options have no intrinsic value at all. Yet in most cases, they still have value; it costs money to buy them. Also in most cases, ITM options have value in excess of their intrinsic value. This is referred to as “extrinsic value” or “time value”.

I prefer the term extrinsic value over time value, because extrinsic value also considers volatility, not just time until expiry.

Have a look at the diagram below of the value of an ATM call option some time before expiry. (All of the following diagrams are for ATM options) The purple area represents intrinsic value and the light blue area represents extrinsic value.

Put options have intrinsic value below the strike price. (See below)

You will note that extrinsic value is greatest when ATM. If we plot the extrinsic value only without intrinsic value, this concept becomes very obvious, an important point for when we get into the Greeks. (See below).

This is the graph of extrinsic value for a call option, but has a similar shape for calls and puts . Note that in this instance the extrinsic value is greater when underlying prices are higher, than when they are lower. This applies to stock options and won’t be seen on futures options. This relates to “cost of carry” because a stock is an actual tangible and will be discussed later in the section on risk free rates.

Next - Time & Time Decay

Buying, Selling And Open Interest

2008-05-02T12:46:00.002+01:00

Buying and selling options is just like buying and selling stock - almost.

They are traded via a broker, have bid and ask prices and market depth, just like stocks do. As a matter of fact with some electronic platforms, you won’t notice any difference.

If you want to buy or sell common stock, you just go into the market and place your order. There is a set number of shares outstanding, issued by the company that never changes unless by corporate action.

Options are different in that the company the option pertains to do not issue them; traders create them out of thin air. This is where the term “Open Interest” is applicable, which I mentioned in the last section, more on that in a moment.

When placing a trade, it is important to tell the broker whether the order is to open or close a trade. If for instance you want to buy 10 INTC May $20 call options that you do not yet own, you would say “buy to open 10 x INTC May $20 call options at x price”. If you wanted to sell those options before expiry, you would tell the broker “sell to close 10 x INTC May $20 call options at x price”.

Similarly if you were going the write the above options, you would say, “Sell to open 10 x INTC May $20 call options at x price”. If you wanted to buy back those options before expiry, you would tell the broker “buy to close 10 x INTC May $20 call options at x price”.

Some electronic platforms will know whether the order is to open a position or to close a position automatically.

This brings me at last to open interest. Open interest is simply the number of open contracts in existence at that point in time. If an option has 0 open interest there are no open contracts. For there to be an increase in the open interest, there must be opening orders on each side of the trade.

For instance in the example above where we bought to open 10 INTC call options, the person selling you those options would have to be selling to open for there to be an increase by 10 in the open interest. That means that there are 10 new call option contracts that have been created in that series.

Likewise, for the open interest to decrease, both sides must be closing orders. For instance in the example above where we sold to close 10 INTC call options, the person buying those options would have to be buying to close for there to be decrease by 10 in the open interest. That means that there are 10 call option contracts that have been closed out in that series.

If however one side of the trade were an opening transaction and the other side of the trade a closing transaction, there would be no effect on open interest.

Open interest is an effective indicator on the likely liquidity of a particular option series. The higher the open interest, obviously the higher the number of traders involved in that contract. This generally results in tighter bid/ask spreads.

By the process known as novation, the person you traded with when you opened a position does not have to be the person with which you close the position. It can be anybody who is in the market at that time. This ensures that you can readily trade out of any position that you may have open; you are not obliged to wait until expiry.

Next - More On Options Pricing

Option Chains & Symbology

2008-05-02T12:39:00.003+01:00

We discussed earlier that options were standardized contracts with various striking prices and expiries available. This is where the options trader needs to make a choice as to which strike and expiry to use. The options available to be traded are viewed via what is known as an option chain, which is simply a list of options.

It is from the option chain that you will choose which option contracts you want to trade. Option chains are available on a number of financial sites, or from your options broker. Public sites may display delayed data so it is better to rely on quotes from your broker.

Below, courtesy Yahoo Finance is an example of an option chain for INTC options that expire in May 2008. Click to enlarge.

You will notice each Option has it’s own unique symbol (N.B. Yahoo adds the .x suffix and is not part of the official symbol). It is important to know this symbol if you are using a full service broker to avoid errors. You can just use the description of the option, but I think it’s better to use both the symbol and the description. That way the chance of a mistake is minimal.

There is a logic behind option symbols and generally the symbol contain letters representing the following: Root symbol + Month code + Strike price code. For a further explanation of option symbols for US options go to http://biz.yahoo.com/opt/symbol.html or the exchange where you will be trading.

Those using electronic platforms might rarely actually use the option symbol, but it is still useful knowledge for statement reconciliation etc. If you are familiar with option symbology, you will know at a glance whether an option is a put or call, the expiry month and strike price. There is other information on the option chain that you will recognize from stock quotes; lets have a look at an individual contract to show what the information is telling us.

Symbol - The symbol for that particular contract.
Last - The last traded price. Please note that the last traded price may have taken place some time ago, perhaps days in some cases and may not reflect the current tradable price.
Change - If there has been any trades today, this will be the difference between the last trade and the previous trade, but as before, the previous trade may have taken place some time ago.
Bid - The current highest price someone is willing to pay for that option.
Ask - The current lowest price someone is willing to sell the option for.
Volume - The number of contracts transacted today.

There is an additional column there titled “Open Interest”, which we will discuss in the next section.

Next - Buying, Selling & Open Interest

Short Or Long?

2008-05-02T12:28:00.007+01:00

Now that we know how to read risk graphs, we can clear up another area that is often confusing to the neophyte options trader, the principle of “long” and “short”.

For this purpose I’d like to separate out two concepts.

1/ Being long or short an instrument (share, future, option etc)
2/ Being long or short the market

This is going to seem blindingly obvious at first, but stick with me on this.

Share traders have uncomplicated mechanics with regards to being long or short. We’re all pretty comfortable with the concept of going long stock. When we are bullish on a market, we want to go long that market. We do this by going long, or buying stock. We are long the market and long the instrument (the stock).

Likewise, if we are bearish on a market, we want to go short on the market, we do this by short selling stock. So we are short the market and short the instrument.

Easy.

The picture with options can become a bit more complicated. Ignoring two, and multi-legged positions, which we will be covering later, it is possible to be long and short at the same time and here is where our risk graphs can help us.

If you buy an option, you are long the instrument. Likewise if you write an option, you are short the instrument. But our market bias will be affected by whether the option is a put or call.

1/ Buy a $50 call with the underlying trading at $50.

This is the same sentiment as being long stock. As you can see we need the underlying market to rise in order to profit. You are long the call option and also long on the market.

2/ Buy a $50 put with the underlying trading at $50. (Assuming no accompanying stock position)

This is the same market sentiment as being short stock, we are bearish and short the market because we need the market to go down in order to profit. Yet we are long the instrument because we bought the put. So in this case, we are long the instrument, but short on the market.

3/ Write a $50 call with the underlying trading at $50.

Here is a case where we are short the instrument, because we have written, or sold the option. We are bearish because we really want the stock to go down so we are short the market as well. But if you look at the risk graph, the stock can actually go up a little bit to just under $52.50 and there will still be a profit at expiry. So in the case of a written call, we can be said to be short the call and short to neutral on the market.

4/ Write a $50 put with the underlying trading at $50.

Finally, the written put, a short the instrument position in the above risk graph is long to neutral on the market.

It’s important to get this concept firmly in your mind as confusion here can lead to execution errors, particularly if using an electronic platform.

In conclusion:

Next - Option Chains & Symbology

Understanding Risk Graphs

2008-05-02T12:19:00.007+01:00

A risk graph is a diagram of the potential profit or loss of an option strategy. I actually prefer the term “payoff diagram”, but “risk graph” seems to have taken a firm hold in options trading vernacular.Many people avoid the use of risk graphs for one of two reasons. They either find them confusing, or they somehow equate the use of a risk graph to charting or technical analysis.

A risk graph is definitely not technical analysis. There is no prediction or analysis of share prices implied by the use of them. They simply make the calculation of potential profit and loss easier for those of us who are more visually oriented, or as a visual estimation tool to shortcut the need for a mathematical spreadsheet.

What I want to do here is to address the confusion factor in understanding risk graphs, by building some risk graphs from scratch.

I believe the confusion factor stems from what the x and y axes represent. Most of us have at least a basic grasp of a price chart, even if not chartists. Most people are aware of what the axes on a price chart represent. The x axis represents the passage of time and the y axis represents price.

However a risk graph does not have time represented on any axis, rather, it is a snapshot at a moment in time, usually at expiry of the option. The x axis, rather than representing time, represents price. The y axis, rather than representing price, represents profit or loss. Below is the risk graph of 100 common stock bought at $50.00, which is represented by the blue line.

I have annotated the risk graph at 3 points. Point A represents the profit of the stock when trading at $50. Because we bought the stock at $50, of course there is no profit or loss. At $56, because we bought 100 stock at $50, there is $600 of profit, which is plotted at point B. At $46, there is a $400 loss, plotted at point C.

Because we know there is a linear relationship between price and profit/loss, we can connect the dots and show the entire risk graph of the common by the blue line. “Passage of Time” is not involved here.

So we can now see what the “hockey stick” shaped risk graph of an option is portraying. Below is the risk graph, at expiry, of 1 x $50 call option (expiry date etc is not important for this example) bought for $2.50.

We can quickly ascertain, that if the option expires with the stock trading at anywhere from $50.00 or less, our loss would be a maximum of $250. We can also see that the stock is required to be trading at $52.50 in order to break even as well as determining the exact profit at any point higher than $52.50.

What about a risk graph of option values before expiry? We can, and should do that too. Below is the same option at the time of purchase, with the common trading at $50.

This presents a somewhat different picture and demonstrates very clearly that the profit and loss picture of an option changes as time goes by. This demonstrates the time decay of long options. With the software I mentioned in an earlier section, we can view the risk graph at expiry, at analysis date and at any point in between, very handy.

The Hoadley software plots both the risk graph at analysis date and at expiry as default, and will perform an animation of the decay process up until expiry. This is very useful for if/then analysis without having to be a mathematics major.

Next - Short Or Long?

Basic Options Pricing

2008-05-02T12:15:00.002+01:00

As we noted earlier, options are derivatives, and are so called because they derive their value from their underlying instrument. Determining the value of options had always been problematic up until the point when in the early 70’s, Fischer Black and Myron Scholes developed the “Black Scholes Option Pricing Model”. The model has been refined and improved over time with alternative equations such as the “Cox, Ross & Rubinstein Binomial Model” being the more usual model used for American style stock options these days.

I shall use the generic term of “Option Pricing Model”, or OPM as proxy unless specifically mentioned otherwise.

I submit that only mathematicians would be interested in the actual formula, and by the miracle of technology we have software to compute this for us non-mathematicians. There is much available on the web on the topic if you’re so inclined.

At this point I would like to introduce a piece of software to you, that I use for pricing and producing payoff diagrams (or risk graphs as they are sometimes known) and will be used extensively throughout this course. It is free for the evaluation version and at less than $100 for the full version it is very inexpensive. I have no financial interest in the product and there are other modelers that are equally useful.

It is the Hoadley Options Strategy Modeler and is available for download at http://hoadley.net/options/strategymodel.htm. All instructions in how to use the software are at the site. I consider it an essential tool for analyzing trades, particularly for those who learn more visually-spatially than by pure abstract. Its real value becomes apparent in analyzing multi-legged spread trades.

The OPM considers six variables or “inputs” in order to generate a price for an option. They are:

The price of the underlying
The strike price
The time till expiry
Risk free interest rates
Dividends, if any
Volatility

At any point in time, the first five inputs are known unequivocally. However for the sixth input, volatility, it is the future volatility of the underlying that must be known. This of course is impossible, so a volatility projection must be made. I will be discussing volatility in depth in a later section.

But here are some general rules of thumb that you can use as a guide, before we get to more in-depth pricing principles:

Higher prices mean higher call prices.
Higher prices mean lower put prices
Lower prices mean lower call prices
Lower prices mean higher put prices
More time till expiry means higher option prices
Higher volatility means higher option prices

Please not that these are general principles and there are several dynamics that can effect the above and I would like to cover some other principles before continuing on with option pricing.

Next - Understanding Risk Graphs

Two Sides To An Options Contract

2008-05-02T12:11:00.001+01:00

We’ve learned that an option is a contract, and we’ve learned what your rights are if you own an options contract. But there are two sides to every contract, right? So if you buy an option contract, somebody has to sell it to you.

The person selling an option contract can be any market participant, market makers, other traders, whoever. It can also be you. This is often called “writing” options and the option seller often referred to as the “writer”.

We’ve learned that the option buyer has the right to buy or sell, so what does that mean for the option writer? That logically translates into obligations for the writer.

Thus, if the buyer of a call option has the right to buy, then the writer of the call option has the obligation sell, if the call owner exercises his/her right. The full statement therefore, is that the call writer has the obligation to sell a certain amount of shares, if called, at a certain price, on or before a certain date.

This is where the term “call” comes from; the option buyer has the right to “call” shares away from the option writer.

Looking at the put side of the equation, if the buyer of a put option has the right to sell, then the writer of the put option has the obligation to buy, if the put owner exercises his/her right. The full statement therefore, is that the put writer has the obligation to buy a certain amount of shares, if put to, at a certain price, on or before a certain date.

This is where the term “put” comes from; the option buyer has the right to “put” shares to the option writer.

In a Nutshell:

The call option buyer has the right to buy.
The call option writer has the obligation to sell.
The put option buyer has the right to sell.
The put option writer has the obligation to buy.

Next - Basic Options Pricing

Options Are Standardized Contracts

2008-05-02T11:49:00.001+01:00

There are two types of option, call options and put options.

The owner of a call option has the right, but not the obligation, to buy a certain amount of shares, at a certain price, on or before a certain date.

The owner of a put option has the right, but not the obligation, to sell a certain amount of shares, at a certain price, on or before a certain date.

In a nutshell, the owner of a call has the right to buy, and the owner of a put has the right to sell.

Options have been traded on all sorts of things for centuries, and on stocks for several decades. But these were non-standard contracts, the terms of which were individually negotiated by the parties involved.

In the US in the early seventies, to expedite the efficient trading of options contracts, the Options Clearing Corporation (OCC) was formed to facilitate the trading of options between stock market participants. The mechanics of how the OCC operates does not concern us in this section and I suggest you find out the activities of the options clearing house in the country in which you live. For the sake of international neutrality, I’ll use the term options clearing house (OCH) as a generic term. Suffice to know that they are operating in the background with the following benefits to option traders:

Options contracts are standardized.
Options exchanges were formed for the trading of these contracts
Market Makers were enlisted to guarantee liquidity
Facilitated the process known as “novation”.

N.B. Novation is the process whereby the person who you entered the contract with, does not have to be the person whom you conclude the contract with. This is another mechanism that ensures liquidity.

Let’s look at the standardization of option contracts. Each option contract will have the following features as set by the OCH

The underlying instrument (e.g. the share the option is on)
Whether the option is a put or call.
The size of the contact. That is the number of shares contained in one contact. The standard contract size of US stock options is 100 shares, but please note that this may vary due to corporate actions during the lifespan of the option. (E.g. share splits etc.)
The exercise price (or strike price as it is sometimes called): This is the price you have the right to buy or sell at, no matter what the market price is.
The expiry date: This is the date up until which you have the right to buy or sell. After this date the option ceases to exist.

American or European

One further distinction, options contracts are classified as either American style, or European style, and refers to when it is possible to exercise your right to buy or sell.

An American style option can be exercised at any time up until the expiry day. Generally options on individual stocks and futures are American style.

A European style option is only able to be exercised upon expiry and cannot be done so beforehand. Some options on broad based indices are European style.

A Couple of Quick Examples

First a call option: The “MA April 18, 2008 220 call option”, an American style option, gives the owner the right, but not the obligation, to buy 100 shares in MasterCard Corporation, on or before April 18 2008, for $220.00 per share.

If MasterCard is trading at, lets say $250 at expiry, you are sure going to exercise your right to buy, if however it is trading at $170 at expiry, you’re sure not going to pay $220 for it and you will let it expire without exercising your right to buy.

Next the put option: The “FSLR May 16, 2008 195 put option” an American style option gives the owner the right, but not the obligation, to sell 100 shares in First Solar Inc. on or before May 16, 2008, for $ 195.00 per share.

If I own FSLR shares which are trading at $160 and I also own the above put option, it makes sense that I might exercise that right and get $195 for shares trading at $160, but if it’s trading at $210, I am not going to sell at $195.

Note that waiting till expiry and either exercising or not, is not your only alternative. You can trade out of the option if that suits your trading plan, but more on that later.

Next - Two Sides To An Options Contract

What Are Options

2008-05-02T11:45:00.002+01:00

OK let’s take a few steps back to the very beginning.

Most investors know that buying common stock entitles them to a part ownership in the company issuing those shares. This means that you have entered into an “equity” participation in the company and in most cases gives the owner of stock the right to dividends paid by the company from time to time and entitles you to a vote in company affairs.

On many companies listed on the world’s stock exchanges, you are also able to trade options. So what is an option?

An option is actually a contract, which gives the owner of the option, the right to buy or sell parcels of shares in a particular company. In this case, these are often referred to as “stock options”, however options can also be traded on ETFs, futures contracts and a number of other instruments. Within the context of this course, I will generally be referring to stock options unless otherwise stated.

It should be noted that options issued by the company to its executives as incentives (and sometimes the subject of controversy) or non-standardized company options traded on some stock exchanges are also called stock options, but these are not included within the context of this course. We are learning specifically about “exchange traded options”
An option does not convey any ownership in the underlying security at all, merely the right to buy or sell a particular security. An option is termed as a “derivative” security, as any value it may have is derived from the value of the underlying security.

Next - Options Are Standardized Contracts

A Quick Word On Risk

2008-05-02T11:41:00.001+01:00

Out there in options land there are various, and sometimes-conflicting statements on the risk involved in options trading. They limit risk, they’re very risky, naked options have unlimited risk, etc. etc. etc.

I want to take this opportunity to dispel any notions you may have about risk in options trading. I’m jumping ahead just a little bit, but now is a good time to get this particular point across. Once again, if you’re a beginner some of the terminology might be foreign, but don’t worry about that right now. As you go through the course, you’ll hark back to this section and it will begin to take on more and more significance; trust me on that.

In any market where options exist on an underlying instrument, whether that is common stock, a futures contract or anything else, there are six possible single leg positions.

1. Long stock
2. Short stock
3. Long call
4. Long put
5. Short call
6. Short put

Let’s say we have the common stock XYZ trading at $50 per share with the ATM options trading at $2.50 apiece (both puts and calls to make it easy) and six traders who each take on one of the above positions.

Important: The presumption is that all the option trades are the same strike price and same expiry.

1. The first buys 100 shares @ $50.
2. The second 2 shorts sells 100 shares @ $50.
3. The third trader buys one $50 call contract (representing 100 shares) @ $2.50.
4. The fourth trader buys 1 $50 put contract @ $2.50.
5. The fifth trader writes (short sells) 1 $50 call contract @ $2.50.
6. The sixth trader writes 1 $50 put contract @ $2.50.

What happens to the profit or loss of each of these traders if the stock is trading at $40 at the option expiry? I won’t go into the mathematics or the mechanics right now, because we’ll be going into that in depth in the course, so you’ll have to trust me on the figures. Brokerage and spread will make a small difference, but for the sake of simplicity we’ll ignore that right now.

1. The trader who bought loses $1,000.
2. The trader who short sold makes $1,000.
3. The trader who bought the call loses $250.
4. The trader who bought the put makes $750.
5. The trader who wrote the call makes $250.
6. The trader who wrote the put loses $750.

There is a lot of analysis that can be gleaned from the above, but what want you to notice in this instance, is the risk of each position. It turns out that the long stockholder has lost the most money. So does that mean that common stock is the most risky? Note also the stock short seller made the most money.

Now I want you to add up all the profits and losses above. Notice it comes to zero.

Again, lets look at what happens if at option expiry the common is trading at $51.00:

1. The trader who bought stock makes $100.
2. The trader who short sold stock loses $100.
3. The trader who bought the call loses $150.
4. The trader who bought the put loses $250.
5. The trader who wrote the call makes $150.
6. The trader who wrote the put makes $250.

In the above example it is the long put trader who has lost the most money, in fact both the long put trader and the long call trader have lost more than the trader who shorted stock, but both the option writers made more than the long stock trader. Does this mean that long options are the most risky position?

Note once again the results all add up to zero.

What I’m hoping you see from this little exercise is that options are not more or less risky than common stock, but that options “transfer” risk. This is apparent in the way that all the sum of all the above position’s profit and loss result in zero. I hope you see that the assertions that you hear about unlimited risk in naked options and that long options reduce risk is largely nonsense.

In fact the person that gravely cautions you about the risk in naked puts, yet will quite happily go long the common, is cognitively dissonant. We’ve shown that in the first scenario, where the long stockholder carries the most downside risk.

Likewise, the person who will indiscriminately buy options to “limit his or her risk” is due a few shocks.

With options, it is not less or more risk that the trader accepts, but they do alter their risk profile. The fantastic thing about options is that you get to select exactly where you want your risk to be and exactly where you don’t want your risk to be.

Now I don’t want to play down the fact that you can lose money trading options. The fact is that you can leverage yourself to ludicrous proportions, and many option traders do just that

This is the really important thing to learn about options trading; understanding exactly where your risks are, how big they are, the face value of your position, what you’ve accepted in order to achieve the particular goal you had in mind, and being aware of how your position may hurt you.

Next - What Are Options

Why You Should Trade Options

2008-05-02T11:24:00.003+01:00

Probably the most common reason people get involved with options is because of the leverage options afford to the retail trader. We've all heard the stories of huge leveraged profits - 100%, 500% 1000%. It is true that these gains are possible on long option strategies, but the reality is a bit more complicated than the big wins. Leverage as we should know, is a double edged sword. Often it is this leverage that prompts people to select inappropriate strategies for their account and risk profile.

If you have started trading options or considering trading options for this reason alone, I suggest it is a very bad reason for doing so because of the nuances of option pricing. You can of course use options for the massive leverage they offer and a few people will “get rich quick”. That is the law of large numbers. But most traders attracted by gargantuan gains and willing to take on the risk, will “get poor quick”, but you don't often get to hear about those. Like any gambler, they only tell you about the wins.

This is not to criticize options trading at all, but there are a number of "good" reasons to trade options.

Let’s look at some good reasons why you should trade them:

* To speculate on the direction of stock with limited risk.
* The hedge a stock or portfolio.
* To reduce capital usage.
* To make extra income from long term stock holdings
* To set buy levels in the market while collecting premium.
* To take advantage of large moves in the market, no matter which way.
* To profit from range-bound stocks.
* To construct specific risk/reward profiles that suit your forward view, even if that view is unclear.
* And yes, leverage, if intelligently applied and providing risk is controlled.

The reason is flexibility. You can create a multitude of risk/reward profiles, rather that “if it goes up you win, if it goes down you lose”. You can use ALL the strategies according to the varying situations you’re faced with, you can use a select few, or you can choose one single strategy and look for opportunities to suit.

I recommend being conversant and proficient with as many strategies as possible, because market conditions can change very quickly and one type of strategy may no longer be suitable for the new conditions.

There are of course, risks in trading options, just like any endeavor where there is reward, and I’ll be comprehensively detailing those risks as we get into the meat of the course.

It is a sad fact that many option traders quit the game after sustaining a few losses where they did not understand the reason for the loss. If I could achieve one thing with this course, it would be to help traders understand exactly where their risks are.

I’ll have a quick word about risk in the next section, before we start into the main course.

Next - A Quick Word On Risk

Introduction To The Options Trading Guide

2008-05-02T11:20:00.002+01:00

The purpose of this site is to build, over time, a free industry standard course on options. A no-cost resource for options traders, or those considering becoming an options trader, to use at will, for however long you like and without having to sign up to any email marketing to clog up your inbox.

Furthermore, it is to be a collaborative process. All sections of the course are open for specific questions on the current topic, constructive criticism, requests for clarification, inclusion of oversights and omissions, etc. I want this to be the best it can be for retail options traders, so your comments are all welcome.

I think there is an unfilled niche for a serious, no BS options guide tuned specifically retail options traders whether they are just starting out, or have a little bit of experience, to take them to the next level. A course written by someone who has come up through the retail trader ranks and knows exactly how you’re all thinking at different stages, and how to progress without having to be super intelligent and overly mathematical.

The goal is to get you to a level of proficiency and long-term profitability.

This will take shape in four stages.

1. The Basics. Just in case you don’t already know.
2. Options Pricing, Volatility & The Greeks. This is an area that is skimmed over or completely ignored by many resources, or it is covered in a highly abstract and technical fashion. This area is extremely important to understand for long-term success and in fact, understanding here opens up a whole myriad of new trading possibilities.
3. The Strategies & Synthetic Relationships. More than a ready reckoner like most strategy lists, the trader needs to be able to think creatively to construct trades to suit his/her view and to achieve the particular goal in mind.
4. Trading in the Real World. In most books and courses, everything is structured in black or white, win, lose or draw. It is all nicely constructed with hand chosen scenarios. But we all know that trading in the real world doesn’t happen that way, don’t we. Stuff happens all the time, so the options traders need to know what to do when things go wrong when and how to defend and adjust positions, how to protect your capital.

Welcome to the journey. I can attest that going to the trouble of learning this properly IS definitely worthwhile.

It is a journey, an apprenticeship if you will, so take your time with this. Learn in small bite sized chunks, absorbing and mastering one concept at a time, take small breaks of a few days and come back to review and move on to the next concept.

To quote an old horseman’s saying: “If you take the time it takes, it takes less time.”

Next - Why You Should Trade Options

Volatility

2008-04-30T14:03:00.001+01:00

The sixth and final input into the Option Pricing Model is volatility.

It is my observation that there is often a bit of confusion about this term. If you listen to any of the financial media, volatility is only ever mentioned when the market is going down. To be sure, a 400-point down day on the Dow is a volatile move, but a 400-point up day is never described as volatile, yet it is equally so.

In the simplest terms, volatility is the relative rate at which the price of a security moves up and down. Market technicians have various methods of measuring volatility, using a variety of formulae, but our option pricing model requires a particular measure of volatility; the annualized standard deviation of logarithmic daily change in price.

Now that's a mouthful, and most option traders view volatility in relative terms without understanding the calculation, but I think it helps to actually understand the mathematics behind it. We can do this with Excel or charting software, which I will give an example of, but let's do it in English first

We start of by calculating for each day's data, today's closing price divided by yesterday's closing price. This will return a number that is today's price as a proportion of yesterday's price. If there is no change, the number will be 1.0, if it is up 2% it will return 1.02, if it is down 5% it will return 0.95 and so on.

The next stage is to find the natural logarithm of the above. This is to reflect the lognormal distribution of stock market returns. Next, multiply this by 100 to express it as a percentage. We can plot this as a scatter chart, which will show the lognormal daily move as a percentage

The next step is to calculate the standard deviation of the above. Normally this is calculated over the last 20 or 30 days of data; it can be any length, but for this example we will use 20 days. This gives us the standard deviation of logarithmic daily change in price, which can be plotted on a chart to see changes in volatility as time goes by. However, Option Pricing Models require that volatility is expressed as an annualized percentage and we do this by multiplying by the square root of the total number of trading days in a year, which is the square root of 252.

This is now the finished volatility calculation, which is called "Historical" or "Statistical" volatility, plotted in the chart below"

This equation can be plotted in charting software to show current and past historical volatility. In Metastock or Amibroker language, (the two platforms I am familiar with) it can be plotted by using the following formula:

(StDev(log(C/Ref(C,-1)),20)*sqrt(252))*100

The above formula calculates historical volatility based on he last 20 days, the figure in red. Any look-back period can be used and some option traders use various length.

So now we can enter this volatility figure into our Option Pricing Model to get an accurate option price; or can we?

The historical volatility number, depending on the look-back period can vary enormously, and as the name implies, looks at past data, whereas what we really want to know as option traders is what volatility will be in the time left until the option expires. As this cannot be known, this forces the option trader to make a volatility forecast, or at least an idea of where volatility might be relative to the present in order to calculate his or her idea of fair value. This where historical volatility can be used as a tool, but the trader must look forward.

Often the market will disagree with you, which I will discuss in the next section.

BUMP - Lessons in Economics

2008-01-31T11:07:00.000Z

I just wanted to highlight these videos on economic by Prof. Krassimir Petrov that I posted back in September. Now is a good time to review them.

Business Cycles, Part 1 of 4 - Introduction, Prof. Krassimir Petrov

Business Cycles, Part 2 of 4 - Business Cycle Indicators, Prof. Krassimir Petrov

Business Cycles, Part 3 of 4 - The Austrian Boom, Prof. Krassimir Petrov

BusinessCycles, Part 4 of 4 - The Austrian Bust, Prof. Krassimir Petrov

Each is over an hour and essential viewing for anyone interested in economic cycles.

Straddles the Safest Strategy?

2008-01-23T12:30:00.001Z

I received this enquiry from one of the members of Aussie Stock Forums which I reproduce with permission:

Hi Wayne

You're an options man so I wonder if you'd mind answering a query. I'm relatively new to options and I've still got a lot to learn, but I've been going quite well with bought puts on US stocks. There's something I'd like to clarify. I've heard that the safest way to trade options is to buy a put and a call at the same time, i.e. a straddle or a strangle, effectively giving yourself a bet each way.
I can see the possible benefits of such a strategy if a stock is flat and there's an earnings report due and you're expecting it to jump one way or the other, but you're not sure which way. But surely the same strategy doesn't make sense if your stock is in a strong trend, has retraced briefly for a few days against the trend, and is now giving every indication that it's about to resume it's trend with a vengeance?
I mean, not only does it put your cost up considerably, but it also kills your profit to a some extent as one of the options would gain rapidly while the other one lost value rapidly (assuming that the stock does in fact make the expected trend resumption).
I guess you could unload the unprofitable one, but if the stock has made a decent move then the unprofitable option would already be showing a hefty loss which would eat into the profit of the other one. Furthermore, if you quit one of the options then it seems to me that you're removing your safety net if the stock was to suddenly reverse and move counter to the trend.
But on the other hand, would you really want to be in an option that was making money only because the stock was moving in the opposite direction to what you expected, i.e. against the trend? I mean, counter-trend moves tend to be short lived.
So, considering the above factors, my thinking is that just a single bought put is the best way to go if the stock is trending strongly but is currently retracing, yet showing sings of imminent trend resumption.

An example of what I'm talking about, the US stock BSC was downtrending strongly when it bottomed out on 9th January, then rallied for a couple of days before topping on January 11. The rally stopped near the Fib 38.2% retracement level, then BSC put in a small range inside day. According to my analysis, this was a good shorting signal if it traded below the inside day.
Now in this situation where the odds are heavily in favour of the stock resuming its downtrend, I can't for the life of me see any reason to buy a strangle or straddle, instead of just buying a single put. With just a single option, if it goes against me I can have a stop in place to minimise my loss. If it goes my way, it has the potential for considerable gains.
Is my thinking correct here, or am I, in my experience, missing something? I'd appreciate your views if you have time to give them.

It's a good question, and one that every options trader ponders as they go on their journey of discovery of this sometime bewildering trading instrument. There are a few concepts to deal with, perhaps if I cover with them one point at a time:

I've heard that the safest way to trade options is to buy a put and a call at the same time, i.e. a straddle or a strangle, effectively giving yourself a bet each way.

I get very annoyed when I see questions like this; not at all at the people asking the question, they are just trying to learn in what is quite a complicated subject. I get annoyed at the ersatz"experts" who spout rubbish like x is the safest strategy, or y is the best strategy.

There is no such thing as the safest or best strategy, there are only strategies that suit your market view, the way you like to trade and volatility conditions. The straddle and strangle are simply strategies for option traders to have in their armoury, to implement when they think it appropriate.

I can see the possible benefits of such a strategy if a stock is flat and there's an earnings report due and you're expecting it to jump one way or the other, but you're not sure which way.

Bear in mind that just about any option strategy intrinsically contains a bet on volatility. This is doubly so with the straddle or strangle. The expected move in the underlying must be greater that that implied by the options price, AKA implied volatility. To see what can happen with regards to implied volatility in this instance see my post - Nike Straddle - Just Do It.

But surely the same strategy doesn't make sense if your stock is in a strong trend, has retraced briefly for a few days against the trend, and is now giving every indication that it's about to resume it's trend with a vengeance?
I mean, not only does it put your cost up considerably, but it also kills your profit to a some extent as one of the options would gain rapidly while the other one lost value rapidly (assuming that the stock does in fact make the expected trend resumption).
I guess you could unload the unprofitable one, but if the stock has made a decent move then the unprofitable option would already be showing a hefty loss which would eat into the profit of the other one.

This illustrates my point about selecting strategies to suit your view and the way you like to trade. This trader has a clear scenario that he wants to trade and should it play out as envisaged, the straddle or strangle would be suboptimal. This trader wants a strategy with negative delta, not delta neutral like a straddle/strangle. This not to say that the straddle wouldn't suit another trader with a different view. It is a matter of understanding the strategy, the greeks, the risks, the potential reward, selecting and implementing a strategy that suits.

I mean, counter-trend moves tend to be short lived.
So, considering the above factors, my thinking is that just a single bought put is the best way to go if the stock is trending strongly but is currently retracing, yet showing sings of imminent trend resumption.

An example of what I'm talking about, the US stock BSC was downtrending strongly when it bottomed out on 9th January, then rallied for a couple of days before topping on January 11. The rally stopped near the Fib 38.2% retracement level, then BSC put in a small range inside day. According to my analysis, this was a good shorting signal if it traded below the inside day.
Now in this situation where the odds are heavily in favour of the stock resuming its downtrend, I can't for the life of me see any reason to buy a strangle or straddle, instead of just buying a single put. With just a single option, if it goes against me I can have a stop in place to minimise my loss. If it goes my way, it has the potential for considerable gains.

In this instance, with this view, a simple bought put could be the ideal strategy to suit this view. The long put is short delta, long gamma, long vega, perfect for a strong down move. The risk is that IV was already quite high and should the stock go against the trader's position, there would be some volatility crush as well. If this risk is acceptable to the trader, perfect.

My view and not to be considered as advice yada yada yada.

Goldman Sachs Tiptoeing Into The Bear Camp

2007-09-27T20:01:00.000+01:00

Blokes like Mike Panzer, Peter Schiff & Stephen Roach have been bears for a long time and while it's nice to have such credible allies for the bear case, at times I wonder if we're all a bunch of fucking "glass half full" nutters and the economy will expand ad infinitum, like the mocking, smirking, asshole perma-bulls seem to think.

But when the likes of Goldman Sachs jumps the fence, it means there must be some substance to the bear view... and it must be close.

No need for further comment from me on this article which appeared in The Telegraph:

By Ambrose Evans-Pritchard
Last Updated: 5:43pm BST 27/09/2007

Goldman Sachs has abandoned its ultra-bullish view of the world economy, warning of a likely recession in Japan and mounting risks that US property slump could spread to parts of Europe.

In a new report, "The Global Economy Hits a Crunch", the US investment bank said it was no longer sure that Asia and Europe would be able to pick up the growth baton as America stumbled. It fears that turmoil is spreading beyond the debt markets to the factory floor.

"Much has changed since mid-July, when we wrote that 'the global economy continues to enjoy one of the strongest sustained expansion in modern history'. The mood in financial markets is clearly darker, and the economic data in the developed world is showing signs of wear," it said.
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"Japan's recovery is tottering, with the chance of an outright recession having risen to nearly two in three," said the report, authored by chief economist Jim O'Neill.

It is an abrupt change of tack for the bank known as the "cheer leader" of the global boom. Until now Goldman has insisted that Asia and the developing world are strong enough to shrug off an American slowdown, allowing world growth to keep racing ahead without missing a step -- despite subprime woes.

Often overlooked, Japan remains the world's second biggest economy and top creditor with some $3,000bn in net foreign assets.

Output had already contracted an annual rate of 1.2pc in the second quarter before the credit crisis hit.

There has since been a surge in the yen as speculators unwind carry trade positions, leaving Japan's margin-trading housewives and grannies nursing big losses.

Wages have fallen for the last eight months in a row. They are now down 1.9pc from a year ago, threatening to pull the country back into deflation.

Goldman Sachs feared it was now "inevitable" that consumers would batten down the hatches for a while.

The bank said Europe is now so weak after a clutch of dire confidence surveys in Germany, Italy, France, and The Netherlands that any further rate rises by the European Central Bank are "off the table".

It expects the euro to fall back to $1.35 against the dollar over the next year, and sterling to tumble to $1.88 as the Bank of England pushes through three rate cuts.

The one bright spot is the 'BRIC' quartet of Brazil, Russia, India, and China, all still firing on four cylinders, if slowing slightly.

In a separate report, "Rising Risks to the Global Housing Market," it said that much of global system had succumbed to a property boom that is in some ways more stretched than in the US, with real (inflation-adjusted) house price rises of over 100pc in France, 60pc in Italy, 55pc in Canada, and 72pc in Australia since the late 1990s. The bubbles in Spain and and Ireland have been more extreme.

"Such a widespread housing boom has little precedent in modern history. In those markets where prices have run up the most, and rental yields have fallen dramatically, the risks of a housing correction are likely to have increased materially," said the note, by Peter Berezin.

"The wealth effect for housing is about twice as large as for equities, with consumption falling by about two cents in the short run for every $1 decline in home prices," he said.

He expects US house prices to drop 7pc in 2007 and another 7pc in 2008, as mortgage lenders shut off credit to chunks of the market. "The US is often a leading indicator for what happens in the rest of the world".

Mr Berezin said construction booms usually lead to housing busts lasting several years. Residential construction in the US reached 6.3pc of GDP at the peak of the bubble, the highest since the baby boom in the early 1950s.

In Spain, it has been even higher, averaging 8.7pc of GDP since 2003, and in Ireland it has exploded to 14.2pc, leaving a overhang of unsold property. House prices are already falling in Spain, where 98pc of mortgages are on floating rates that have roughly doubled since late 2005.

Property prices have dropped for the last four months in a row in Ireland.

Mr Berezin said the Goldman's "decoupling" thesis was based on the assumption that the US housing slump was a "country-specific-shock" that would not spill over into other economies. This was now in doubt.

"The spread of global credit risks has introduced a new potential transmission mechanism. If home prices in the key economies begin to fall, this will have an adverse effect on global growth," he said.

Bears on Message

2007-09-25T17:39:00.000+01:00

I've been totally slack about blogging the last few days. Partly because not much is happening from my economic perspective (in terms of things to write about) and partly because I am feeling a bit deflated/disappointed at the recent Fed actions. I really feel it is the worst thing they could have done for the health of the world economy in the medium term.

Anyway, while I recover some enthusiasm for writing shit on the internet, have a look at this video. It is Glen Beck interviewing couple of my favourite bears, Peter Schiff and Michael Panzer (who's blog, Financial Armageddon appears in my blogroll)

Rate Cut Post Mortem

2007-09-20T20:49:00.000+01:00

As you know I have my own feelings about Helicopter Bens's rate cut. In case you haven't been following along, I think it was an extraordinarily bad decision and each member of the FOMC should be strung up by their balls. I've been dieing to comment from a bush economists point of view (and have been ranting and raving offline), but really wanted a more professional opinion for this blog.

As usual, Mick Shedlock delivers the goods with some excellent analysis in Bernanke's Bullet Misses The Mark. Here is a synopsis taken directly from the article:

List of What's Changed
Perception has changed.
Any perception of the Fed as being concerned about inflation went out the window.
Any perception of the Fed as being concerned about the dollar went out the window.
Bulls are happiest they have been in months.
The stock market is higher.
Gold is higher.
Oil is higher.
The Prime Rate dropped 50 basis points.
List of What Hasn't Changed
Mortgage Rates. (Actually mortgage rates rose since last week as the chart below shows).
Auto Loan Rates. Nearly identical to last week.
Home Equity Loan Rates. Nearly identical to last week.
The outlook for jobs. (If anything the outlook is weaker judging from the Fed's panic).
Credit Card Interest Rates.
The foreclosures outlook did not change. It is still bleak.
The Fundamentals Have Not Changed
Massive numbers of foreclosures are still going to happen.
Banks are going to be stuck in huge numbers of REOs.
Home inventories are still rising.
The economic ship is still sinking
The jobs market remains grim

Please read the whole article as it makes a whole bunch of sense.

As expected & noted, there has been movement in the markets; The USD is taking it up the ass, and Metals, Oil and other exchange rate sensitive markets are flying. The really curious movement to me was in the long bonds, both in the US and Europe. Since the rate decision, the contracts I follow closely and trade, The Euro Bund and The 10 Year T-Note have been down strongly and in fact accelerating today in big one day moves.

If you don't happen to know what this means, it means that longer term bond yields, which mortgages and other long-term are priced off, ARE RISING, as indicated in the 10 year YIELD chart on the left.

I am on record as holding the view that rates should in fact be rising and I think that once liquidity is normalized somewhat, Bernanke will be forced to raise again. But on the long end of the yield curve at least, the market is doing what the Fed doesn't have the balls to do. Those who have painted themselves into a corner in the housing market won't be getting any relief and nor should they. (Though I do feel sympathy for how the market and mass psychology have compelled them to make unwise decisions. The psychology used by vested interests is very strong.)

In conclusion, the shipwreck is still on course, a .5% cut proves it. The only area where I remain bemused is why equity traders are bullish.

10 Priciples of Economics

2007-09-18T21:43:00.000+01:00

"Mankiw's 10 principles of economics, translated for the uninitiated", by Yoram Bauman

This is a really good watch. :-) From Calculated Risk.

Goodbye USD!

2007-09-18T19:24:00.000+01:00

0.5% is a very fucking lousy decision.

I'll let the real economists mull over than one, while ignoring the capitol hill sycophants.

At Last! A Voice of Reason.

2007-09-17T21:07:00.000+01:00

Sort of. Katherine Mann says hold interest rates... but doesn't think a recession is on the cards. Hmmmmmm.....

The UK Mortgage Lender Implode-O-Meter?

2007-09-16T18:31:00.000+01:00

By now just about everyone will know about the Northern cRock bank run on Friday and Saturday. I haven't posted till now for fear of merely regurgitating what is already posted in depth all over the freaking internet.

I have been amusing myself with pictures of queues outside branches like the one on the right... well, OK it's a photoshop job just for fun.

The only problem is that there are a lot of folks who won't be thinking the whole situation is funny at all. There will be hundreds of Northern Rock customers who will be having sleepless nights over the weekend, worried about the security of their investments; like the poor old lady below who stood in the queue for hours to get her money out, only to be turned away at closing time by the local constabulary. I feel for them.

Internet customers are having a hell of a time logging on and accessing their accounts amid suspicions that bandwidth has been deliberately restricted to stem the hemorrhaging of funds from the bank.

Of course everybody from the NR CEO, to the press, to the Chancellor of the Exchequer is saying that the bank is sound and that people funds are safe. But these parties are not known for telling the truth are they? Depositors obviously feel discretion is the better part of valour and taking their funds elsewhere. I can't say I blame them one iota.

Unquestionably, there is no way that NR can continue in it's current form, so basically the first mortgage lender in the UK will very shortly cease to exist.

That makes me wonder if some enterprising Englishman/woman has kicked off a UK version of
The Mortgage Lender Implode-O-Meter, because it might just be the first of many. Sub-prime lending in the UK has been rife and has been hidden by strong price appreciation to date and folks have been able to sell or MEW themselves out of trouble. But with the first month on month falls recorded, those days are over.

Regarding the future of the UK property market, I think there is a sound opinion here in the following video:

No matter what exactly transpires next, (I suspect governments and CBs will desperately try to prop up the boom) The world changed in August and things will be different and harder from now on.

The Myth Of The Perpetual Boom

2007-09-14T10:28:00.000+01:00

In "The Age" today there was an article detailing how loan defaults have risen 30% in Australia over the last financial year. Read It.

That's not really what I wanted to concentrate on. There are literally hundreds of articles bringing to attention the signs of a world economy going over the falls. No need to regurgitate too much of that here.

The bit that caught my attention was this statement:

...And economists say consumers who haven't experienced a recession are upping their borrowing to levels more than double their income because they are confident the good economic times will continue.

This is something we bush economists of an Austrian bent have been commenting on for some time now. There are many folk that have either never experienced a recession, or who have forgotten that they can occur.

Only recently I was speaking to quite a successful small businessman who refused to concede even the remotest possibility of a recession... not just in the immediate future, but ever! LOL! Anyway, I changed the subject pretty smartly to conserve a friendship.

I notice even experienced economists who speak on Bubblevision seem to imply that recessions are just not on the cards anymore.

WTF?

I think the contrarian indicator is invokes waaaaaayyyyyy too early these days, (It's fashionable to go against the tide ). I often think it's a good idea to fade these "early" contrarians, but in these days where everybody knows about the contrarian indicator, and hence its inappropriate use, surely there must come a time to fade the faders who are fading the faders. lol.

In other words, in the quote above, is there a "genuine" contrarian signal? There sure are lots of bears about at the minute, but the great unwashed masses are still unrelentingly bullish.

Riches to Rags In The City

2007-09-13T19:37:00.000+01:00

In the last few posts I've been speaking about the now well known problems in the credit markets, and how this is starting to affect London property prices. Of course yje property perma-bulls refuse to concede that falls in prices are possible; real estate only ever goes up don't you know?

History and a few deft keystrokes in Excel disprove that, but for falls to become a reality, there must be vectors that exert downward forces. I've mentioned the vanishing bonuses, but how about unemployment? I'm not talking about factory workers and builders any more, I'm talking about suits.

Check out this blog from the BBC's Robert Peston LINK:

Scything the City

Robert Peston
13 Sep 07, 07:45 AM

The humungous bonuses trousered by many investment bankers may seem a trifle de trop.

But it’s not a stress-free existence. They live in an eat-or-be-eaten world and are in work for as long as they are economically productive - and barely a second longer.

So brutal redundancies are now only days and weeks away, as it becomes commonly accepted that the turmoil in financial markets will depress certain lines of business for months if not years.

The boss of one investment bank tells me he expects a first wave of job cuts that will see individual banks reduce their headcounts between 5 and 15 per cent.

And he says he wouldn't be surprised if that was followed just a few months later by a second wave of similar or even greater magnitude.

First out the door will be many of the creators of the current crisis: the manufacturers and traders of assorted asset-backed securities that you can hardly give away right now; all those debt whiz-kids who engineered the poisonous collateralised debt and loan obligations; the banking servants of a hedge-fund world that’s shrinking fast and of a private-equity industry in cryogenic storage.

Should we weep for their plight? Some of you will scoff at the thought. It’s a big hello to schadenfreude.

Actually, there could be one or two benign consequences from the slaughter of the not-so-innocent, such as a deceleration in the rampant inflation of central London property (okay, I know this is not a universal good).

But don't think we'll get away scot-free.

The economy called Britain is built on financial services (though more by accident than design). Something over a third of our overall economic growth has been generated in recent times by the City and financial services.

Lean times in the City means slower growth, less wealth to spread around and a substantial dip in the Treasury's tithe.

When the bubble is pricked, no umbrella is big enough – we all become a bit damp.

There are still corpses to float to the surface in this whole credit crunched scenario IMO. Bearing in mind the gravity of what happened in July-August, things are just a bit too quiet to be real.

What Are Gold & Oil Telling Us...

2007-09-11T18:30:00.000+01:00

...if anything?

Well yeah, it's partly to do with the dollar doomage, but I think there is more to it than that. Both gold and oil are threatening, or threatening to threaten multi year highs. In the case of oil, all time highs.

First gold: There is the gold is money argument, so it's natural that gold will rise as the dollar tanks. I don't go along with that 100% but what I think matters nought. If enough folks with enough capital think so, it is so. Perception is reality. Add to that the speculative froth once the public gets onto the bandwagon and in the current environment we could see some real boomage here. To a certain extent, I think this could be starting to happen. The gold bugs are certainly starting to froth at the mouth on all the trading forums.

weekly continuous gold

In recent months it's been grinding sideways frustrating the crap out of all but option writers, but this move is starting to look fair dinkum.

On the the other hand, oil is threatening to take out its all time high. There are probably plenty of bullshit fundamentals to justify this, and if of an apocalyptic bent, one simply must be a crude oil bull.

weekly continuous west texas sweet crude

The $64,000,000 question is the future of the price of oil in the medium term, presuming the world economy goes into recession. It would be expected that a recession would lessen oil consumption and result in declining prices, sans any killer 'canes obliterating the Gulf of Mexico or similar.

Long term, you just have to be a bull.

I'm glad I have some rudimentary charting skills because the fundamentals are often too full of biases, bullshit, short term considerations and rigs getting blown over.

An all time high in pretty short shrift seems like a high probability in the near term.

Back to the question posed at the beginning. Is this trying to tell us something? Something other than the purely native fundamentals of these two commodities? If it is, I suppose it will be loud and clear in a relatively short space of time.

The Streets of London

2007-09-09T07:18:00.000+01:00

For a couple of years now, there has a been a growing crowd that have become bearish on the UK property market. The bulls cite a number easily disproved fallacies as to why they think property prices will rise well beyond inflation ad infinitum. Shortage of housing, we are an island, high immigration etc etc etc, all of which were cited in the last boom did nothing to stop the bust when it came in the early 90's.

A study of business cycles and a few columns in Excel will quickly dispel the mathematical absurdity of the perpetual boom. Indeed, regional England has been seeing price stagnation, and even falls in some areas. Even Northern Ireland has apparently hit a wall as desperate vendors drop asking prices to shift their overvalued hovels.

Ahh but London, that paragon of all that is coveted in this bourgeois ego infected planet; Harrod's, Covent Garden, Mayfair, the West End and so on, has been stubbornly, defiantly rising in the face of all rationality. There have been two main reasons for this. The UK's favourable tax treatment of non residents has seen billions of pounds pouring in from wealthy foreigners, snapping up all the fashionable real estate. Most recently, this has been coming from the Russian oligarchy. The second factor is the absurdly oversized bonuses financial sector employees have been receiving, due to the recent credit and equities boom.

I mean, what do you do with a Christmas bonus that would make the GDP of a small African nation look like pocket money? Why, buy real estate of course!

We bush economists have been wondering though, how the recent credit market heart attack would effect the City boys. The answer came via the Financial Times:

City bonus fears hit prime market
By Jim Pickard and Sharlene Goff
Published: September 7 2007 20:16 | Last updated: September 8 2007 05:18
Property purchases are coming under pressure in the wealthier London districts after gloomy forecasts for end-of-year City bonuses.
Estate agents have reported some deals falling through, while mortgage brokers have seen a number of active buyers put their property searches on hold, for fear they will not receive the bumper payouts they had hoped for.
House prices in areas popular with City professionals, such as Mayfair, Kensington and Chelsea, rose at their slowest pace for a year last month as the impact of the credit crunch took hold. FULL STORY

While the article states that rises have merely slowed down and no falls recorded, it can't be long before there are MoM falls as the credit crisis plays out.

Now things get interesting. The signs of an impending Austrian bust are everywhere and the ball is in Bernanke's hands, though the general consensus is that he can only provide a rear-gaurd action, giving the smarties enough time to get the hell out of the way.

Sub-Prime Mess Contained

2007-09-08T09:19:00.000+01:00

A leading economist said today that there is no evidence that the sub-prime contagion will spread beyond the stratosphere. Meanwhile, the credit crunch is starting to involve the cheap tat buying public.

Families have been warned of a looming credit drought as banks and building societies stop handing out cards and overdrafts to hard-pressed households

Industry experts have said that lenders are clamping down on debt applications for fear that borrowers default as the economy worsens.
It is the latest evidence of how the financial markets crisis is affecting households and follows news that mortgage companies are primed to increase their interest rates, causing more hardship for hundreds of thousands of households due to renew their home loans in the coming months.
Equifax, a company that provides credit checks, said households would find it increasingly difficult to borrow money in the coming months, as lenders started to refuse more and more applications. FULL STORY

I think this will have a quantum effect on retail sales... perhaps even accelerate mortgage defaults. I know plenty of folks who are doing the credit card boogie to make their over-committed ends meet, all the while building more and more debt. Another signal we bush economists take note of.

Jobs

2007-09-07T18:51:00.000+01:00

So Wall Street economists were expecting ~+115,000 on the NFP number.

Really?

The building industry is hemorrhaging jobs from the great gaping hole in its aorta and I suspect there would be a few real estate broker sending CVs around at the moment too; and the NFP was a shock?

"It's a major shock to the market," said Peter Cardillo, chief market strategist at Avalon Partners. "If the job market continues to weaken, fears of a recession will continue to accelerate, calling into question corporate earnings."

You have to wonder about economists. I mean I have an interest in economics and though no formal degree, I would consider myself what would be termed here in Australia as a "bush economist". This is someone who basically has been fucked by not knowing about business cycles before and has learned to "sniff out" when things are starting to get out of whack.

We bush economists have been worried about sub-prime, stretched asset values and rampant malinvestment for a couple of years now while the smirking Wall Street assholes have been bullshitting on about Goldilocks economies.

We have also been wondering how long birth and death models and other such nonsense could disguise the real state of employment. When you get an actual drop of 4,000, it's time for folks to pull out their CVs and polish them up for a potential mass mail out.

But look and the bright side, it's another factor for Uncle Ben to justify a rate cut.

The logic goes: slowing economy => rate cut => bullish => market rally

Yep, Goldilocks rules... along with other fairytales

So WTF Exactly, is Going On?

2007-09-06T19:35:00.000+01:00

Is the Gold upage a harbinger of more uncertain times? What the fuck is going on? B-52s flying around with nukes by "mistake", Russian bomber fleets flying with Jet fighters in puruit?

Holy Crap!!

US B-52 in nuclear cargo blunder

The US Air Force has launched an investigation after a B-52 bomber flew across the US last week mistakenly loaded with nuclear-armed missiles.
It follows reports in the Army Times that five missiles were unaccounted for during the three-hour flight from North Dakota to Louisiana. FULL STORY.

... and then:

U.K., Norway Send Jets to Intercept Russian Aircraft (Update2)
By Robin Stringer and Sebastian Alison

Sept. 6 (Bloomberg) -- Four U.K. Royal Air Force Tornado jets were launched to intercept eight Russian strategic bombers, the British Ministry of Defence said. Two aircraft from the Norwegian air force also trailed Russia's planes.

The RAF Tornado F3 jet fighters were scrambled early today to intercept the Soviet-era Russian bombers ``which had not entered U.K. airspace,'' the ministry said in an e-mailed statement. The ministry didn't elaborate on how close the RAF aircraft got to the Russian planes. FULL STORY

This is a rather apocalyptic development and could explain gold why gold is getting of its arse and doing something. Renewed Cold war tensions anyone?

Still some ways to go before gold looks like a new trend, but it's been worth paying attention over the last few days.

Eyes wide open for a couple of reasons here.