Not sure I’ve ever seen a single trade get this much press. But Don Fishback finds this reference to The Most Important Options Transaction Ever.

Can’t take it anymore. I’ve seen this too many times to not comment. Yesterday, a reporter for the Washington Post’s “The Ticker” wrote:

“At least one trader today placed a nearly $1 million bet that the VIX will rise above 45 by July, buying several thousand option calls.”

No, No, NO!

Just because somebody bought a million dollars worth of options does NOT mean that that person thinks volatility is going to 45. People buy options for 2 reasons: speculation and hedging. There is simply no way to know from the information presented in the article that this VIX call buyer was a hedger or a speculator. If the person was a hedger, then by definition they think the most likely event is that volatility is not going to go to 45, but they want to be protected in case it does. They bought volatility insurance!

It refers of course to the 20,000 lot of VIX 45-55 call spreads that went up last week.

Basically, following options order flow for directional clues is more art than science. When I was on the floor way back when, you kind of sort of kind of could get a feel for which players you wanted to follow and which ones you wanted to fade. But even that’s far from a path to riches.

And like Don says, who ever knows exactly what the player is doing overall. Even if you did, it’s still not a lock you want to follow them directionally or not. And let’s put this particular trade in perspective. Again, it was a low delta, way OTM call spread in the VIX. Remember it’s a VIX future, which this far out we figure will track about 40-50% of the VIX move. And even with the recent rally, the VIX still has a 31 full. Yes, you don’t need the VIX to actually go to 45 and above to win big on the trade. But as Don notes, 38 sure would work. We’re nowhere near that yet, and truthfully to get there you’d need to see the VIX in the 40’s as July would move to a discount.

To put it on today, note that the June 75 straddle costs $8 with $1 of intrinsic value. So the market’s best guess is that RIMM will go to 82 or drop to 67 or so. One way would be to sell June 65 puts and buy July or Sep and sell June 80 calls and again buy July or Sep. Look at the post on the Savient Pharma trades for details and profit diagrams. Also, look at the results of the SVNT trades – very important, You can be right and still lose money.

I sold the June 70 calls and bought two July 80 calls for each one sold. That is a bet on good results, with a defined loss if it goes the other way. Just a punt. The dual calendar might be a better way to go.

OK, apparently caused lots of dissenting opinion in regards to slapping on a spread that involved going long VXX and short SPY near term options.

So let me clarify a few points.

This is just a convoluted way around a relatively simple trade, an SPX or SPY calender. So what if we forget VXX and VIX futures exist. The basic thought here is

when volatility caves, I generally would prefer owning calenders. That involves buying longer dated options at likely a higher volatility than I am selling the shorter term options. It gets me short gamma and earns money in the form of time decay.

You have to look at this as two separate transactions though. The short side of the options will earn me money if the realized volatility between now and expiration is less than the volatility I sold them for. Yes, part of that trade likely involves chasing stock into strength and shorting it into weakness. The idea is to lose less doing that than you earn in options attrition.

The long side of the calender is more of a bet on implied volatility at least holding steady. You will not lose all that much time decay, but you are at risk of a move lower in volatility. But if you think options volatility is a buy longer term, you are OK with that.

So combine the two and you are effectively betting on longer term implied volatility to outperform shorter term realized volatility. If you think that’s a good bet, a calendar makes sense.

Using VXX or a VIX future in lieu of a longer dated SPX or SPY option is not identical, but you will win or lose with it in a similar pattern as above.

But it’s important to remember however you chose to go long a longer dated option, it’s not a big deal if you “buy” higher volatility than you sell. It’s two different time frames and two very different bets, there’s no reason they will or should carry the same volatility. A few weeks ago they all did carry about the same volatility. That’s more unusual than not.

So what’s the risk in buying a calendar, or buying VXX and shorting SPY options?

It’s not that some small volatility difference between the two cycles will revert to 0. There are 2 big risks however. One is that realized volatility, which you are effectively shorting, will explode and longer term volatility will not lift as much. You would have got hit massively with that last Fall. Which is why I don’t like this position in a rising volatility environment.

The other risk is that all volatility caves in. Your short volatility will only earn you so much, I mean your options can only go to zero and you will get lousy prices trying to roll them. Meanwhile your VXX or VIX future or longer dated SPY straddle has gotten mauled.

Post getting long here. To be Continued.

Here’s a take on today’s VIX move that’s so useless it almost had to come right off the CNBC website.

The stock market’s main fear gauge moved past a key level on Monday, indicating possible troubles ahead for the market.

And one options player with deep pockets is making a big bet that volatility will increase sharply, making this a tumultuous summer.

The Chicago Board Options Exchange Volatility Index, or VIX, moved past 30, a mark it hasn’t closed above since June 4. A VIX reading of better than 30 generally indicates high volatility that usually accompanies stock market drops.

Following suit, stocks lost more than 1 percent.

Oh, where to begin.

There’s nothing “magical” about VIX 30. The move from, say, 29.75 to 30.25 bears no more signficance than say, the move from 30.25 to 30.75. In fact, the VIX is a contrary indicator. Higher levels indicate more fear, on a contrarian basis is actually bullish.

And it’s completely absurd to define today’s action as the VIX lifting and stocks “following suit”. Aside from the obvious fact that stocks were down 1% before the options marts even opened, it’s akin to the logic that umbrellas cause rain.

So what was this big trade? We mentioned it earlier, but here’s some more color.

The joint moves in the VIX and stocks come just a few days after a big investor bet on the VIX caused tremors in the options market.

One trader on Thursday bought 20,000 July VIX calls at the 45 strike and sold 55 strike calls for an overall premium of 42.5 cents in a trade that cost about $850,000 to execute. The net impact is that the VIX would have to beat the 45.42 level by the July expiration for the investor to make money. The VIX hasn’t been past 40 since April 21.

“The last few weeks we’ve come under 30 and we’ve been under 30 as investors became more sanguine in their approach,” said Andrew Wilkinson, senior strategist at Interactive Brokers. “This was a standout trade that went against the grain.”

While there would be no direct correlation between such a huge trade and the actual VIX movement, the bet could be indicative of a shifting mood.

Let me get this straight, for $850,000 of cheap VIX spread caused tremors in the options marts? The spread has a delta of about 8 now, after the lift. Meaning someone hedging the other side only has to buy about 1 VIX future for every 12 spreads he does. Which would have modest upside impact on the future, but really not cosmic. Especially since as a vertical, it’s defined risk, and will likely be underhedged.

Could this be indicative of a shifting mood?

It could. It could also someone hedging a portfolio that has had a nice run. It could be someone taking a cheap VIX shot. It could be a desk with Variance risk just closing something off. It could be Lenny doubling down.

What it can’t be is all that meaningful. There are countless trades of this size each and every day all across the floors. If someone can move entire markets by purchasing $850,000 cheap OTM VIX spreads, we have bigger issues to deal with than we realize.

This is what I’m looking at for tomorrow.

Pinning Candidates

It looks like the top two, Goldman Sachs and Apple, are prime candidates to be pinned at 120 tomorrow. Goldman announced earnings early this week, so there shouldn’t be a lot of news out tomorrow to move the stock. That is, unless Citibank’s earnings announcement tomoorw morning shakes up all the financial stocks.

Google

Google is all over the place in after hours trading after its earnings announcement.  Who knows if it will stabilize tomorrow morning near a strike.  The open interest is wide and deep for Google options.  So we will have to see at 10AM.  It might happen that Google will have momentum tomorrow so that a more directional bet would make sense.  If it is moving up, then one could buy a call just above where it opens and sell two or three calls at the next higher strike to pay for it and make the trade close to delta neutral.

Rest of the List 

Research in Motion (RIMM), First Solar (FSLR), and Mastercard (MA) are good candidates too.  The others on the list, Autozone (AZO), Baidu (BIDU), and Chicago Mercantile Exchange (CME) don’t have very many puts. So they aren’t very good candidates for pinning.

Monte Carlo Results

What is the probability of a successful trade? Which trade is the most likely to succeed? To answer these questions, I ran the Monte Carlo simulation for each straddle. The inputs are the stock price, the straddle price, the number of trading days left, the interest rate, and the historical volatility of the stock. The output is the probability that the stock wanders past the break even point on either side.

Some of these look better than others.   The best one is Google, only a one percent chance that it will wander outside the break even points.  Of course, this isn’t correct.  The volatility of the straddle will collapse tomorrow morning making the break even points closer together.  We will have to recalculate that one in the morning.

Notice how different GS and AAPL are.  Though they are at the same stock price as can be seen in the top table, and the at the money straddles are the same value, the trades are very different.  It is because Goldman Sachs has a much higher historical volatility.   

I believe that the probabilities are upper bounds, because of the extra pinning effect of the options on either sides of the strikes.  Still, I would sell more straddles of the stock that had the lower probability.

How can we trade this? If we bought April 7.50 straddles, both the put and call, we would benefit from any large move that AA made on Wednesday. But what will happen to the implied volatility? Once Alcoa has its conference call, the company’s best guess about the coming quarter is out. Implied volatility will collapse and the straddle will lose value. So buying the straddle is a bet on a big move of the stock and that the implied volatility will not decrease too much.

How about selling the April straddle? Here we profit when volatility collapses, but get killed if the stock moves a lot.

What to do?

I consulted the good book, Options As A Strategic Investment (see Recommended Reading), and read the chapter on volatility trading. McMillan mentions that there is a trade that will profit from an increase in volatility. That means that we can put on the opposite trade and profit from a volatility collapse. It also has the added advantage that we can put it on for a credit, my bias, and that it will profit slightly from a big move in the stock.

Before I reveal my answer, here is the data for the options as of this morning, before the market opened. See if you find something better.

AA price: $7.93 all options have a $7.50 strike

Remember, delta is how much the call increases in value for a $1 increase in the stock price; and vega is how much the option increases in value for a 1% increase in the implied volatility of the option.
Calendar Spread

My idea is to sell a calendar spread. The usual calendar spread is to sell the April option and buy the May or July option. That profits from an increase in volatility as you can see by subtracting the vegas, 0.015 – 0.005 = 0.010 Gain a penny for every percent increase in the implied volatility. Since we are looking to profit from a drop in volatility, we do the reverse, buy the April and sell the July. We get a credit of $1.59, we make money if the volatility drops, and we have a slight profit from a large movement in the stock since the deltas are slightly different.

Looks like a good trade to me.

Yesterday  I discussed the Genentech (DNA) Roche Holdings merger and that I sold puts on DNA.  Every day Genentech has had a leg up so that the puts I sold have gotten cheaper.  So yesterday, the puts were bought in for a quarter.  There is no premium left in the March options, so there is nothing more to do there.  If you sold the April 95 calls and the April 90 puts you could earn $0.85 in premium for the pair.  That might make sense since Roche Holdings will succeed in buying DNA for $95.  If instead you sell the April 95 straddle, both the put and call at a strike price of 95, you would earn $1.25.  In that case, if it closed below 93.75 on April 18th, you would have a loss.  Since targets usually trade at a discount to the purchase price to allow for unforeseen problems with the purchase, the first trade seems a better bet.  The danger in selling the calls is that there appear a new suitor to DNA and they try to bust their acceptance of Roche Holdings’ offer at $95.  This would be a difficult thing to do because Roche already owns 56% of the company.

So I just sold the 90 puts.

NLY and HTS

In a previous post I wrote about selling puts on NLY and HTS and then selling stock to stop the losses.  Today I bought in the puts since they were cheap and I have an order in to buy the stock back at a lower level than where they are trading now.  If I am not filled, I will turn it into a market on close order.

The final reckoning:  I sold the 10 NLY puts at 0.7 for a credit of $700 on 23 Feb.  I sold 500 shares of stock at 12.40 on 6th March.  Today I bought in the puts for 0.3 and the the stock market on close at $14.37  so I made $400 on the puts and lost $985 on the stock.  Net -$585.

On Hatteras Financial I sold 10 puts at $0.8 each for a credit of $800.  I sold 300 shares of stock on the 6th of March for 21.57.  I bought in the stock today, market on close for $24.36 and I bought in 5 of the puts today at $0.1 and five of them Wednesday for $0.35.   I paid $50 for the puts today and $175 for the puts on Wednesday.  So on the puts I made $575; on the stock I lost $837 for a net loss of $262.

Better than I thought.  Selling the stock helped lessen the losses.

Buffett Wrote Puts

So it is no wonder that Buffett is also willing to write puts on the stock market as a whole.  Actually, he has written $37.1 billion worth of puts on four stock markets, he has sold SP500 puts (US market), FTSE 100 (UK market), Nikkei 225 (Japanese market), and the Euro Stoxx 50.  Some of the contracts come due in 15 years and others in 20 years.  They are all European style, they cannot be exercised before expiration.  The reckoning is when they expire.

As an example, BRK-A may have written $1 billion on the SP500 when it was at 1300 and received $100 million – $150 million in premium to use for the next 15 years.  If in 15 years the index is at 1170, down 10%, BRK-A would have to pay $100 million.  If it is above 1300, they pay nothing.

Because the index is now at 713, BRK-A has a large loss to record.  Accounting rules insist that the puts be marked to market and so they show a large loss now.   But what is the probability that the index will be below 1300 in 15 years?  That is how Buffett really thinks of his risk.

To get to 1300 from 713 in 15 years, the index would have to increase by 82%.   In order to increase that much in 15 years, the index would have to grow by 4.1% per year.  Inflation runs more than 2% per year, so the real increase per year would have to be 2.1% per year.  This seems like a very good bet, the US economy grows at 3% per year on average.

Cost of Funds

What if the index stays at 713 for 15 years?  Berkshire Hathaway would have to pay $452 million to their counterparty.  (If the index went to zero, they would have to pay $1 billion, 713 is 45% of the way to zero).   In this case, they had the use of $1 billion for 15 years, at the end of that period they have to pay $452 million.  What do they have to earn every year in order to have that money to pay back?  If they can earn 2.5% per year for 15 years, BK will have $1.452 billion at the end of 15 years.  Their cost of funds will have been 2.5%

That is a very good deal.

We cannot do the same thing because brokerages insist that we put up margin for the trade.  Buffett will not enter into a contract where he has to put up collateral.  He wants to be able to use the float to invest.  That is his model.

But there are good trades for us too, get my free CD, “7 Secrets to Make $1,000 Per Week Trading Options”.