I ran a few Monte Carlos to see if it mattered if you sold the near month versus the far and to get a feel for how often you would have to adjust given where you choose to play. These are for the Russell 2000 index, RUT.

So here, this close in, it doesn’t matter if we trade the near month, October or November. We’d have to adjust all the time, though it would close past one of the strikes between 60% and 65% of the time.

What happens if we move farther out?

This is much more manageable. One has to adjust about 25 – 30% of the time, though the market closes past one of the strikes less than 20% of the time.

Next question is, what happens if you don’t adjust? Take your lumps when the market closes past your short strike but sit with it and make the return when the market turns back around. Is that a good strategy or poor one?

Stay tuned.

Some traders use options to speculate on the price movement of an underlying asset; other traders use options to speculate on changes in the volatility, implied or realized, of that asset.  Put a little differently: while no options trader can afford to ignore the role that volatility plays in the price of a contract, not all options traders are interested exclusively or even primarily in volatility. If you’re essentially a stock picker who likes to lever up by buying puts and calls, know that many options traders are doing something different from that.

Recall that there are three components that affect the value of an option: price, time, and implied volatility.* Changes in the price of the underlying asset will affect the price of an option on that asset, as will the passage of time and changes in expectations of future volatility. We measure the exposure an option contract has to those three components and report them as the greek variables delta, theta, and vega. (Vega is not a Greek letter, but it is a greek letter.)

Now, if you’re an options trader of the second type – i.e., not just a stock-picker on steroids – and you have a view to express about volatility, then you’ll want to reduce your exposure to other irrelevant variables. It’s like running a business: if you know you’re good at selling insurance, and if you’ve become one of the biggest and the best insurance companies around, then if you’re smart you’ll think twice before risking your entire company on your ability to make sausages (or to sell OTC credit derivatives, which isn’t so different: you put a lot of nasty stuff in a sack and hope not to hear from your buyers anytime soon).

That’s why options traders and authors in academic finance journals spend so much time thinking about delta hedging. It’s not really an optional line of inquiry, if you’ll pardon the pun: hedging away unwanted risks is a key survival tactic.  Traders who have a consistently profitable thesis about (or skill at trading) volatility will only be profitable overall if they can reduce or eliminate the impact of variables other than volatility. Delta hedging of some form or another is a necessary but not sufficient condition for successful options trading.

In the followup to this post, we’ll look at some popular methods for hedging away delta risk.

* Of course, interest rates and other carrying costs matter, too, but not nearly as much, and not enough to warrant discussion in this post.

… the subject du jour, the seemingly odd VIX expiration settlement.

The VIX closed Tuesday at 32.69, yet on Wednesday it “settled” at 31.03 with a pretty flat SPX open.

The real oddity though is that June futures closed Tuesday at 31.80, an oddly large discount to the VIX. Now they don’t have to close identically, but 3% off does seem high.

So put in that context, the VIX settlement at 31.03 is not quite as off as met the eye. What was off was the actual VIX close.

Which leads me to think I should practice what I preach. I note often that the VIX is not exact to the point, and never a perfect reflection of volatility in the market. For whatever reason, the calculation on Tuesday night overstated the VIX. The VIX lifted about half a point late in the day. Maybe an SPX put buyer walked in late, maybe the SPX cash closed incorrectly, I really don’t know and it really doesn’t matter. VIX futures and options traders clearly knew the “runup” didn’t mean anything.

Again, the VIX is a stat. There was no arb here, there’s no actual VIX you could have sold at 32.69 then covered on Wednesday’s open. You could have sold VIX June futures at a 90 cent discount and made money however.

So while upon further review the 31.03 settlement does not look quite as absurd, it’s still a bit low, probably a point or so. Which highlights the most important lesson in all this. If you do trade VIX or VIX options, do close anything in or near the money before the cash out, otherwise you’re just playing a lottery on whether you win or lose on the runoff.

How to explain the mystery?

Look at the following table of bank stocks:

S is where the stock closed today, X is the strike that I am comparing the May call implied volatility to the out month implied volatility.

So we can see here that PNC isn’t the only one. It must be that there is a volatility skew for the banks for which options traders think will be affected by the results of the stress test. Next Monday, May 4th, we will see if this volatility skew goes away.

The Wall Street Journal leaked some preliminary results this morning.

Go to Yahoo! Finance and see the WSJ video discussing Citi and Bank of America.

There is nothing wrong with condors and limiting loss is the most important thing that you can do in trading.  But the fact is, there is no trade that is without risk that can earn more than the risk free rate.  The risk free rate now is one half of one percent at the short end of the yield curve.

If there was a trade that earned more than the risk free rate, arbitrageurs would borrow at the risk free rate and put on the trade locking in a profit.  Then the trade would go away since they would do the trade in size.

Delta neutral trades are a favorite with the mathematicians.  That is, trades where you either buy a put and a call at the stock price or near it or sell the same.  The problem is that delta neutral trades do not stay neutral.  The stock underlying it moves and the trade is out of whack.  No longer neutral.

What to do?

Recognize that you will have to fix the trade.  With that in mind,  start the trade small.  If you were going to sell 30 puts and 30 calls, first sell 10 of each.  Then when the trade goes bad, close it out and redo it larger to make up for the loss on the first smaller trade.

This brings us to position size.  No trade should be more than one to two percent of you r account.  That way, you do not damage your account with a small loss.  This is a whole treatise in itself.

There are five pieces of information that fix the price of an option. Four of them are open for anyone to see. They are the price of the underlying stock or commodity, the strike price of the option, the time to expiration of the option, and the interest rate. The last hidden variable is the most important – the implied volatility.

Volatility is how much the price moves around. If the price were fixed, the volatility would be zero. If the price bounced wildly the volatility could be 100%. With the large drop in the stock market last fall, all volatilities have increased. The market as a whole has a volatility, measured by the VIX , of 40%. This measures the expectations of traders for the fluctuations of the market.

Last fall, the VIX hit 100%

The highest reading ever.

To have the best chance for a trade to pay off, you have to see where you are in the volatility cycle. Is the volatility relatively low for Apple? Maybe that means it is a good time to buy options. Is the volatility relatively high for Apple? Then you want to sell options.

If you buy options, the risk is limited to the price of the option.  So it looks like the ratio of risk to reward is low.  That is, there is a high reward and low risk, the best of all possible worlds.

If you have a system for predicting the movement of stocks or commodities you can do very well, it seems.  If there is a high probability that a stock will go up, you buy a call and wait for it to double.  If there is a high probability of a stock to fall, you buy the put and wait for the stock to fall, your put climbs in value.

It’s not quite that easy.

Even if you get the direction right, you can still lose money.  There are other elements to options.  One is time decay.

UPS for Example

Let’s say that you believe that UPS is going to fall in price, US consumers are saving money, not spending, shipping volumes are way down, there are lots of good arguments.   So you buy a put that expires in a month.  UPS is trading at 43 and the March 40 put costs 2.  March expiration is 47 days away.  What would it take for the put to go to $4?

The March 45 put is at 4.20 / 4.40 and is a little over $2 in the money.  That tells us that for our put to go to $4, we need it to be about $2 in the money, or UPS would have to trade at $38.  This doesn’t take into account that we lose time value of the option each day.  After all, if UPS is at $38 and we are a few days from expiration, our option will only trade at $2. There is no time value left.

So we need UPS to move soon.

How large a move do we need?  From 43 to 38 is 5 or about a 12% move.  To estimate how likely this is, we can ask, when did UPS trade 12% higher?

It traded around 50 on January 13.  That was twenty days ago.  So if it is still falling, it might fall another 12% in another twenty days or so.

This is cutting things too close for me.  I would not do this trade.  We haven’t even discussed how the implied volatility might affect things.