# Trading Options Volatility



## wayneL (8 July 2006)

Hi Folks, 

From my new blog thevolatilityreport.com (NB Non commercial)

***********************

I wanted to show you one way you can trade options using volatility.

The stock I want to show you is Forrest Laboratories FRX. FRX has suffered a bit of a decline from a high of over $48 in February down to about $36 in June and is currently trading at circa $39. The reason for this decline, apart from a general market decline in the same time period, is that FRX is involved in a court case regarding one of its pharmeceutical lines. The exact details are not important to us.







However what is important to us are the volatility levels. Take a look at the 12 month volatility chart below.






The blue line is the 30 day statistical volatility and generally oscillates around the 20% level… highs of ~35% and lows of ~15%. But have a look at the gold line which is the mean implied volatility.

Firstly, notice that IV is almost always a few points above SV. These options are chronically overvalued which mean genarally we have an edge with written strategies. But look where we are at present! IV has topped out at ~70% while SV is languishing at around 20%. We DEFINiTELY need to be writing options.

The trouble is, we don’t know which way this baby is going to jump, that’s in the hands of the judge. So, delta neutral? Long straddle is out of the question due to the low gamma and vega risk. Short strangle? This could miss the goalposts by a mile, too much uncovered risk. Butterfly/Condor? This would put a bit of a lid on risk, but we could still miss the goalposts with no chance of morphing the position if it gaps.

OK, there’s one thing we haven’t looked at is volatility skew, the tendency for different strikes and different expiries to have different IV levels.

With FRX, the longer dated options has lower IVs. This is called time skew, and is quite normal in these circumstances.

But there is also strike skew, the tendency for different strikes within the same expiry to have different IVs. This is often refered to the volatility smile, or volatility smirk, depending on the shape. In FRX’s case it was a smirk, because all the strikes above the ATM strike, had higher IV’s than the lower strikes. This time skew combined with strike skew can be a great opportunity to put on a very low risk trade.

Generally, we want to be buying low volatility and selling high volatility.

Now there was 31% at the $50 Jan 07 calls and there was 85% at the $35 Aug calls. There was also 65% at the $40 ATM Aug call which I ekected to take because the extrinsic value is still highest ATM.

So I sell the Aug $40calls and buy the Jan $50calls? Well yes! But that would give me a bearish diagonal spread, and seeing as I want to be market neutral, thats not what I want.

So how about a ratio? More long calls than short calls, giving me a calendarized backpread. That works well at a ratio of 2.5:1 giving us a payoff diagram like this:






Now I want you to notice something. The bottom blue line is the payoff today, the top blue line is the payoff at expiry of the Aug calls. So what do you notice? huh huh?

No risk!

Technically there is vega risk in the long back month options that could cause a limited loss at around the $45-$46 mark at August expiry. But I got those at 31%!! They don’t get much cheaper for this stock! My model says we could collapse down to about 20% before taking a loss in that area, but everywhere else you look there’s profit.

There are further tweaks that I have made to this trade, but we’ll just leave it there and see what happens come August.


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## Mofra (8 July 2006)

In one post Wayne has given us more useful, practical information than most expensive seminars. 

Very much appreciated.


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## sails (8 July 2006)

Hi Wayne,

This trade reminds me of a discussion on Jason's forum some time ago!  I remember spending hours trying different combinations.  A ratioed diagonal is one strategy I sorta ruled out due to the extra longs in the back month and impending IV crush. 

It's a shame that these types of opportunities don't exist in Aus options for those of us that don't like the night shift.

Don't have a lot of time just now, but will have a closer look into it a bit later and get back to you with some questions or comments.

Also, didn't realise Hoadley had a new version out with all those pretty lines  until you posted your graph    Have just downloaded mine and it looks pretty good - thanks!

Cheers,
Margaret.


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## omad (8 July 2006)

I have some questions for you Wayne, sorry if they are a bit basic.

1. Any reason you use 30 day SV and not a different time frame? 

2. How is the mean implied volatility calculated?

3. How would one graph volatility like this for Oz shares?

4. How did you work out that a ratio of 2.5:1 works well?

5. What sort of adjustments might you have to do, if any?

6. Is this how you look for all your option trades, looking for volatility opportunities as opposed to your views on direction?

Thanks for the great post.


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## Magdoran (8 July 2006)

Nice trade Wayne,


I just love these “diagonalised” ratio positions – here’s my risk graph based on the natural prices currently...



Regards

Magdoran

P.S. - Omad, when Wayne responds he’ll probably answer that a 5:2 ratio gave the best risk to reward characteristics...  and this is why you use a risk graph to determine the best parameters.


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## wayneL (8 July 2006)

sails said:
			
		

> Also, didn't realise Hoadley had a new version out with all those pretty lines  until you posted your graph    Have just downloaded mine and it looks pretty good - thanks!
> 
> Cheers,
> Margaret.




Peter Hoadley is rather sneaky with his updates. I have learned to keep an eye on what he's up to.  It's turning into quite an excellent, low-cost tool.

Cheers


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## wayneL (8 July 2006)

omad said:
			
		

> I have some questions for you Wayne, sorry if they are a bit basic.
> 
> 1. Any reason you use 30 day SV and not a different time frame?
> 
> ...




Cheers


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## wayneL (8 July 2006)

Magdoran said:
			
		

> Nice trade Wayne,
> 
> 
> I just love these “diagonalised” ratio positions –




Thanks! 

As an aside, you wouldn't believe the number of traders who have bought straddles over this. :screwy:


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## NettAssets (8 July 2006)

Thanks for that Wayne,

Quite an eye opener for someone still taking baby steps.

John


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## wayneL (9 July 2006)

Here is the Amibroker Code for 30 day statistical Volatility


```
x =(StDev(log(C/Ref(C,-1)),30) * sqrt(252))*100;
Plot(x,"30 day SV",colorRed,styleThick);
```

For Oz options I created the following code:


```
base = (StDev(log(C/Ref(C,-1)),100) * sqrt(252))*100;
acc = (StDev(log(C/Ref(C,-1)),10) * sqrt(252))*100;
x1 = acc - Ref(base,-1);
x2 = (x1* (2 / (10+1) ) ) + Ref(base,-1);
Plot(x2,"Expo SV",colorRed,styleThick);
```


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## hissho (9 July 2006)

excellent stuff Wayne.

questions:
1) does the software use real-time data to give real-time volatility? do you have to stay up all night to watch it and catch an opportunity when it presents itself?isn't it time-inefficient?

2) is it true that you need both Amibroker and IVolatility.com for OZ options, and only need IVolatility for US options?

3) apart from some big household names like Coke, GM, Google, Yahoo, Apple etc i've got no idea about US market. What's the best starting point?

thanks a lot
hissho


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## wayneL (10 July 2006)

hissho said:
			
		

> excellent stuff Wayne.
> 
> questions:
> 1) does the software use real-time data to give real-time volatility? do you have to stay up all night to watch it and catch an opportunity when it presents itself?isn't it time-inefficient?
> ...




Hi Hissho

Disn't see your post. I will answer these questions later today.


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## wayneL (10 July 2006)

Here's another one with massive IV...Kinetic Concepts KCI (another court case  )

Will be having a look at this tonight...subject to liquidity etc.

Cheers


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## flyhigher (10 July 2006)

sorry for dummie questions from newbies:
1. Based on my limited understanding, you've short short-term options with high IV and long Long term Options with low IV. Are you expecting that IV will collapse in Short term and increase in the long term? are you also expecting stock will move up in the medium term as well?
2. Are premiums collected enough to cover the risk if stock stay 42-45 at the end of August?

thanks for your excellent example and sharing the knowledge.
cheers


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## wayneL (10 July 2006)

hissho said:
			
		

> excellent stuff Wayne.
> 
> questions:
> 1) does the software use real-time data to give real-time volatility?
> ...




Cheers


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## wayneL (10 July 2006)

flyhigher said:
			
		

> sorry for dummie questions from newbies:
> 1. Based on my limited understanding, you've short short-term options with high IV and long Long term Options with low IV. Are you expecting that IV will collapse in Short term and increase in the long term? are you also expecting
> stock will move up in the medium term as well?
> 
> ...




No worries


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## sails (10 July 2006)

Hi Wayne,

I had a good look at the trade over the weekend and also came up with $46 as being the worst level for August expiration.  I only took IV down to 25% and found about $5,000 loss at this level.

Assuming 19th August expiration and FRX closing at $46 with 25% IV, the Jan07 $50 calls would be worth about $1.86 and the $40 Aug calls would cost $6.00 to close:

$60,000 to close Aug $46 calls
$46,500 value remaining in Jan07 $50 calls
= $13,500
Less $8,570 Initial credit
= $4930 loss

Have I made a mistake somewhere - perhaps wrong quantities or other imput into Hoadley?  Probably something obvious    

Just like to know where the risk is hiding    

Cheers,
Margaret


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## wayneL (13 July 2006)

sails said:
			
		

> Hi Wayne,
> 
> I had a good look at the trade over the weekend and also came up with $46 as being the worst level for August expiration.  I only took IV down to 25% and found about $5,000 loss at this level.
> 
> ...




Just an update on this trade... but first:

Margaret was correct here in pointing out that there was more vega risk than I had calculated. I had one incorrect input into the software which messed up the if/then scenario. 

NOTHING gets past Margaret  

I could change the structure of this trade to accomodate this risk, however the reason I put this trade on in the first place is that my volatility projection for the back month is for no change. This stocks options don't get much cheaper as I pointed out. So I will leave it as it is.

So this from the blog............

Though I’ve only had this trade on a few days, there’s been a nice little change in IV’s in my favour. The IV on the short front month $40 Aug calls has dropped 7 points down to 58% whilst the long back month $50 Jan calls have maintainted their IV level.

The stock has moved down a bit and I am getting a little bit of a helping hand from gamma. I could close this out now for a respectable profit… but I won’t yet. The only risk in this trade is vega risk on the back month at around the $45-$47 mark on the underlying, but I’m not worried about any IV dump there.

This is just an update to show how volatility can be used in trading… and this is pretty much a pure volatility play. 

Cheers


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## sails (13 July 2006)

wayneL said:
			
		

> Just an update on this trade... but first:
> 
> Margaret was correct here in pointing out that there was more vega risk than I had calculated. I had one incorrect input into the software which messed up the if/then scenario.
> 
> ...



...and I thought I had miscalculated somewhere    

Don't usually dissect trades so thoroughly, but have been interested for a while in ratioed diagonals and so pulled it apart to see how it might work out.   

Do like the Hoadley update - especially the new feature where IV can be increased or decreased on the new "Time and Volatility Modelling" page - great for calendars.

Have back tested diagonals (with and without ratios) on the Aussie market but just can't get them to look right - usually too much risk.  But then we don't get a lot of IV skew between months either.   Magdoran, if you have time, would still be interested in looking at some past examples?

Agree Wayne, that it is still a high probability trade with only a small area of risk (and unlikely) near August expiration.  Good to hear it is moving favourably for you.

Cheers,
Margaret.


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## Magdoran (15 July 2006)

sails said:
			
		

> ...and I thought I had miscalculated somewhere
> 
> Don't usually dissect trades so thoroughly, but have been interested for a while in ratioed diagonals and so pulled it apart to see how it might work out.
> 
> ...



Hello Margaret,


Sure, I’ve been doing a lot of modeling recently with ratio back spreads (and I had a query on ratio spreads too recently), and also for diagonal back spreads too.

Good work on working out the weak spot of the diagonal ratio back spread.

The risk with these positions is that the sold positions either move too much in the money and are exercised (particularly if there isn’t much time value left – or there is a dividend coming of value with the call versions), or they are going to expire in the money...  Another enemy is IV crush specifically in the bought position.

So, you have to calculate how to manage these positions right from the start – rules can be developed to manage the risk.  Certainly, IV crush to the bought position can be a problem, but this is why selling as much volatility is important, to mitigate adverse IV effects on the bought position.

I agree that it is worthwhile having a program that can simulate IV movements to see how this affects a strategy.  A lot depends on the initial IV skew.  What I’ve found from experience is that you should aim for a strategy where the bought IV is not likely to suffer anywhere near as much from IV crush as the sold position.  But even so, there certainly can be exceptions in market outcomes, that’s for sure.  

Where you have a problem is when the IV crush affects the bought position adversely more than the sold.   A negative affect is of course possible, but unlikely if you enter in the right conditions, aiming for the point move to be within a range.

In the case Wayne used for an example, he’s basically betting the stock will either move very bullishly or stay at the current level or below during the life of the sold position:

•	He wins (while the sold strikes are still open) as it nears his bought strikes and above as long as the IV of the bought strikes doesn’t fall too much– which is unlikely for a fast moving stock – IV tends to increase in this case; 
•	Or the stock will stay at the same level or below if it moves sideways or bearishly, in which case he keeps the credit – the danger here is the IV crush for a sideways movement – strong bearish moves should see IV increase more than decrease.

The less likely event is that the stock moves up putting the sold position ITM but not moving enough so the bought higher strikes despite their greater ratio don’t gain enough value in time, if the sold positions are exercised, or expiry looms...

This approach works best if the sold positions expire worthless, but the outlook is still favorable for the bought ones, looking for them to move ITM preferably before 30 days to expiry, or that they are moving ITM in under 30 days so the theta decay is not too severe if there is a good chance of a continuing favourable movement.

Firstly there is a graphical representation of a normal ratio back spread at expiry to illustrate what it looks like without the diagonal.  Then there are examples at expiry of the diagonal with different levels of IV crush.  Note that you would need a big drop in IV.

Now, the examples I have used have a simulated IV similar to the one Wayne found.  This is not usual for the Australian market, but does happen in the US market from time to time.  So the charts are purely illustrative.

The final chart on the next post shows how it was possible for a 66% IV to have been reached, and the low probability of the IV crush happening.

For these style of positions, you really have to assess a wide range of variables, and IV modeling as Margaret illustrated can be very important.


Regards


Magdoran


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## Magdoran (15 July 2006)

Here's the volatilty chart which wouldn't fit on the last post


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## Magdoran (15 July 2006)

One more point, the simulation for the diagonal ratio back spreads postulated a uniform drop in IV to both bought and sold positions.  Often the high IV for the sold position moves further than the bought, which means we are effectively looking at the worst case end of the scenario.


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## ducati916 (15 July 2006)

> Technically there is vega risk in the long back month options that could cause a limited loss at around the $45-$46 mark at August expiry. But I got those at 31%!! They don’t get much cheaper for this stock! My model says we could collapse down to about 20% before taking a loss in that area, but everywhere else you look there’s profit.




FOREST LABS CL A (NYSE:FRX) Delayed quote data  

Last Trade: 44.00 
Trade Time: 2:21PM ET 
Change:  5.60 (14.58%) 
Prev Close: 38.40 
Open: 43.93 
Bid: N/A 
Ask: N/A 
1y Target Est: 47.68 

  Day's Range: 43.17 - 44.94 
52wk Range: 34.54 - 48.51 
Volume: 13,959,300 
Avg Vol (3m): 1,814,010 
Market Cap: 14.15B 
P/E (ttm): 21.13 
EPS (ttm): 2.08 
Div & Yield: N/A (N/A) 


Currently approaching the danger zone after winning a patent ruling.
How [if at all currently] does the management of the trade alter?

Currently $43.86


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## ducati916 (15 July 2006)

CALL OPTIONS Expire at close Fri, Aug 18, 2006 

Strike Symbol Last Chg Bid Ask Vol Open Int 

35.00 FRXHG.X 9.50  3.98 9.30 9.50 170 3,108 
40.00 FHAHH.X 5.00  2.40 4.70 4.90 14,908 19,665 
45.00 FHAHI.X 1.40  0.65 1.40 1.50 7,659 27,051 


CALL OPTIONS Expire at close Fri, Jan 19, 2007 

Strike Symbol Last Chg Bid Ask Vol Open Int 
25.00 FRXAE.X 20.20  4.20 19.80 20.10 270 382 
30.00 FRXAF.X 15.10  3.40 15.20 15.40 31 170 
35.00 FRXAG.X 10.80  2.80 10.80 11.00 19 1,472 
40.00 FHAAH.X 6.80  1.90 6.80 7.00 1,266 7,964 
45.00 FHAAI.X 3.60  1.15 3.60 3.80 22,868 19,907 
50.00 FHAAJ.X 1.70  0.80 1.65 1.75 2,819 14,885


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## wayneL (15 July 2006)

The trade is not in a really good spot. The back month IV has dipped a bit, but not disaster.

However I still have 5 weeks left in the trade and will have a closer look over the  weekend. But I'm looking at selling a aug 45-50 ratioed straddle<edit- let's try strangle>, but havent made up my mind yet exactly how to defend this. 

Cheers


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## sails (15 July 2006)

Wayne - hope I didn't jinx the trade    - but looks like Mr Murphy has stuck his nose in where he's least wanted...

According to my calculations, you could actually still close this out for a small profit (unless you’ve already spent all your credit   ).  If that’s so in reality, not a bad outcome to be near the worst case scenario and still make a profit!  Anyway, all the best with it!


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## sails (15 July 2006)

Hi Mag,

Thanks for the detailed reply with so many graphs included – much appreciated!  

I have put the trades into Hoadley, but not getting the same results as OptionGear.  I thought initially it may have been because IV was dropped uniformly on both bought and sold positions in your graphs, however, your black line seems to be set for zero days which would mean it shouldn't affect the sold position anyway (NB a little difficult to see the fine print in the picture, so please correct me if this is not set to zero).  I will check my imputs again to make sure they are correct.

As we don’t get these nice vol skews here in Aus, what criteria would you be looking for before putting one of these on?  I would imagine one would be potentially rising IV to help the back month along.

I was also interested in the IV chart you posted for BHP showing quite a few IV skews.  I only get average IV from WebIress in chart form so I will check individual months a bit more often from now on.  

Thanks again!

Margaret.


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## Magdoran (16 July 2006)

sails said:
			
		

> Hi Mag,
> 
> Thanks for the detailed reply with so many graphs included – much appreciated!
> 
> ...



Hello Margaret,


You’re more than welcome, hope my knowledge is complementary to yours… you obviously know your stuff!

I know I haven’t talked in much detail about diagonals, and that’s because of two reasons – one it’s really involved and there is a lot of work to explain the nuances, the other is I’m kind of reluctant to reveal some of my IP to the public – especially when there’s the potential for market makers to figure out the weaknesses of anyone who’s using my approach…  I hope you understand.

As for the examples I put up, the differences in our results is probably due to a number of reasons.  Firstly, I have custom option models I configured myself which will give very different results from “stock standard models” (forgive the pun) - I use different models for different markets, and trade candidates.  Secondly our samples may be from a different source/time, and some of the information that you and I entered into the analysis may be subtly different. 

I also cheated a bit by skewing a few things around so they’d look right to simulate the curves the way they should look theoretically… hence some model values will be untrue for market conditions, but this was done deliberately.

Regarding modelling, I tend to use binomial (American exercise) in preference to Black and Scholes (B&S has some problems with its asymptotic resolution algorithms, and can return false or erroneous values in some situations), and then I sometimes modify the sample band widths, a choice of either implied skews/implied average/historical, a choice of expiry ranges, different mixes of calls and puts, and I can also input real or projected dividends.

As you can imagine, this can sometimes come up with very different results when there are so many variables involved.  As you know, theoretical values are exactly that.  The actual market price can be radically different from the theoretical; hence the multitude of opportunities that exist if you can project what will happen in reality with some accuracy – which of course as you know can add an extra edge in your favour.  One of my edges I suppose is aiming to be adept at modelling, but I’m still learning every day…

With the examples I put up, you are correct, I set them at expiry of the sold position to show the core shape of the strategy, which would also illustrate the effects of IV graphically.

As for the Australian condition, I have found that you need specifically designed approaches that are “outside the square”.  In essence, the orthodox way of looking at these is hampered by lack of liquidity in many cases, so you need to be a bit more creative how you morph these, and that is a significant part of the equation… 

The IV chart is one of many configured views available that I have developed (or pinched if someone figured out a better approach – the setting you see here is like Optionetics Platinum settings for calendars for example). 

I have developed sets of IV charting configurations I built to suit different conditions and strategies, and I can just toggle between these and switch lines on and off that I want to see (or not).  If I’m going to play diagonals, or any kind of “calendarised” approach, sometimes there are skews in different expiry ranges that can present potential opportunities. 

There are specific IV charts you can configure to look at this at a glance.  You can also use the deciles pattern below to quickly look at the relative value within a time range that you can select.  You can also update this information by accessing the Hubb data base on demand.

Regards


Magdoran


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## wayneL (16 July 2006)

sails said:
			
		

> Wayne - hope I didn't jinx the trade    - but looks like Mr Murphy has stuck his nose in where he's least wanted...
> 
> According to my calculations, you could actually still close this out for a small profit (unless you’ve already spent all your credit   ).  If that’s so in reality, not a bad outcome to be near the worst case scenario and still make a profit!  Anyway, all the best with it!




Hi Margaret,

Mr Murphy is always expected, if not welcome. He is the neighbor thats pops around to for a cup of sugar, stays for a cup of coffee, then a beer, then a few beers, dinner, late night movie, and falls asleep on your loungeroom floor. When you finally get rid of him, you find he's emptied the fridge, burnt a hole in your favourite chair, spilt red wine on your nice white carpet, and left the toilet seat up (and other unpleasantries) to boot.

And we are expected to remain good humoured through all this?

We all know we must, it goes with the neiborhood. Anyway, I digress....

Here is the challenge... exit, sit still, or morph?

And here is where I must have a view of where this stock is going.

It's true that the news was favourable and it's true that FRX has recieved analyst upgrades. But it's also true that this market looks like death.... and then there is that gap. The back month IV could even return to 30% or higher before the August expiry. The stock could close the gap and end up @ $40, it could keep running through "the valley of the shadow of death" and up the other side to $50.

For the moment I am struggling to come up with a definitive view so think I'll sit tight and see if the market gives me a clue, meanwhile hedging delta with underlying.

Stay tuned.


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## sails (17 July 2006)

Hi Mag,

I did use the binomial American pricing model and all the other imputs into Hoadley seem to be fine, however, Hoadley came up with approx. $100 profit at July expiry should the stock close at $31.50 and IV remains unchanged (as per your entry pricing).  Your pay-off diagram shows approx $500 profit – this is a significant difference on a small trade. (NB: I used $31.50 simply because that is the lowest point on the graph and the easiest to line up with the small type price scale.)

Similarly, the other diagrams with IV’s adjusted by different amounts, there is still about the same $400 difference.  As you explained, you did deliberately skew the results but I'm still somewhat mystified at the huge amount of difference when we are just using the same two calls, same IV, same pricing model, same stock price, same quantities and entry price, same expiry dates, etc.

Interestingly, the left side of the graph is exactly the same as Hoadley which reflects the $550 credit, although some smaller differences in the max profit amounts.

Anyway, no problem if you prefer not to discuss these types of trades anymore - understand if they are proprietary.  I got the impression from some of your earlier posts where you raised the subject of diagonals that this was something you were happy to discuss – so my apologies if I’ve misunderstood.

All the best,

Margaret.


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## sails (17 July 2006)

wayneL said:
			
		

> ...Mr Murphy is always expected, if not welcome. He is the neighbor thats pops around to for a cup of sugar, stays for a cup of coffee, then a beer, then a few beers, dinner, late night movie, and falls asleep on your loungeroom floor. When you finally get rid of him, you find he's emptied the fridge, burnt a hole in your favourite chair, spilt red wine on your nice white carpet, and left the toilet seat up (and other unpleasantries) to boot.
> 
> And we are expected to remain good humoured through all this?...



LOL - good description of the guy.  Still, he keeps us on our toes.

Sounds like a good  plan to let the dust settle for a few days and see if there is any sign of direction one way or the other.    

Staying tuned....


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## Magdoran (17 July 2006)

sails said:
			
		

> Hi Mag,
> 
> I did use the binomial American pricing model and all the other imputs into Hoadley seem to be fine, however, Hoadley came up with approx. $100 profit at July expiry should the stock close at $31.50 and IV remains unchanged (as per your entry pricing).  Your pay-off diagram shows approx $500 profit – this is a significant difference on a small trade. (NB: I used $31.50 simply because that is the lowest point on the graph and the easiest to line up with the small type price scale.)
> 
> ...



Hello Margaret,



Sorry, when I read my post (28) on this thread, it occurred to me that my comment on discussing diagonals was ambiguous… I did actually mean I was happy to discuss these with you in the public forum, but with some limitations… I didn’t mean I won’t talk about these at all, just that some of the things I do may not make complete sense without all the reasons being addressed.  But the primary difficulty is in constructing good scenarios…

Please understand that sometimes it is actually quite difficult to address your questions as fully as I’d like to, both because some of the issues are actually quite complex (and sometimes there are holes in my knowledge too), and in some cases some critical parts of my thinking I don’t really want to post up publicly as mentioned…  so please, no apology required at all, and please accept mine if I appear inconsistent – It is in part because we are dealing in a very competitive environment, and prudence requires discretion.

I hope that sort of makes sense…  I am genuinely trying to be as helpful as I can.

Now, as for the BHP model, let’s just do a check list to make sure some of our inputs are the same:

Were the entry prices the same? (1.23 and 0.34)
Was the entry IV’s the same? (66.8% & 35.1%)
Was the contract size the same? (Ratio – 2:1)
Check the strikes and moths again too just for good measure…


If these are all the same, then that would make me think it was something in our modelling.  I was using American exercise binomial, using an implied average for the full spectrum of strikes.  I skewed the entry prices to reflect the kind of conditions you’d consider using this kind of spread in based on the high IV in the front month.

Other than that, I’m really not sure why we ended up with different results… it would be interesting to know, wouldn’t it?

As for diagonals, there are so many different approaches – which market, liquidity, width of the different strikes, IV skews, ratios (how much) or not, different width in the time frame, a lot of T/A events/conditions and how to use which version and when, and how to manage it (this is where some of the IP is), how to play the market maker (a lot of IP here)…  Also, what time frame the trade is designed for … risk levels and management… the list goes on.

Therein lies the challenge – how on earth do I address this subject? - and I have thought about it, believe me.  At some point I’m may even be asked to stand up in front of an audience and explain this – I really don’t know if I can explain it succinctly, and I still don’t have a crystal approach in mind yet… but I’m working on it…

So, Margaret, perhaps you can suggest a framework, or an approach…


Regards


Magdoran


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## Magdoran (17 July 2006)

wayneL said:
			
		

> Hi Margaret,
> 
> Mr Murphy is always expected, if not welcome. He is the neighbor thats pops around to for a cup of sugar, stays for a cup of coffee, then a beer, then a few beers, dinner, late night movie, and falls asleep on your loungeroom floor. When you finally get rid of him, you find he's emptied the fridge, burnt a hole in your favourite chair, spilt red wine on your nice white carpet, and left the toilet seat up (and other unpleasantries) to boot.
> 
> ...



Hi Wayne,


I’ve had a look at your position, and put myself in the place of someone in this trade – now, this is not financial advice, but this is what occurred to me if I was trading in this situation, and what I’d tend to do…

Have a look at the attached charts, and the risk is really in a further IV slide… other than that, if the stock trends up strongly, there is unlimited reward, and if it falls heavily it can also return a good profit.

Have a look at the risk to reward in the risk graph and see what you think… not much risk, and lots of reward, and time is not really working against you as long as the stock moves into the profit areas around expiry time.

Key risks are exercise (but you can handle this), and IV crush to the bought position.  But look at the volatility chart…  I would have thought that there is a reasonable chance that the IV will tend towards the mean, won’t it?  That’s not a bad thing…

The T/A worst case is that it creeps sideways from here and the IV falls off in the bought strike, and it stays in the maximum loss zone.

Now, look at the stock, and tell me if it usually trades sideways or is volatile.  If it keeps moving, I’d be looking for profit exits if I thought it was going to move back to the loss area.  Otherwise I’d be letting it trade and make an assessment as it approached expiry for the sold positions, with a plan on how to manage these (when to buy them back, and wether to sell the bought position).


I actually think the graph looks reasonable as a trade right now based on the entry.  The risk to reward still looks attractive to me… just look at the graph and make your own assessment - what do you think?


Regards


Magdoran


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## sails (18 July 2006)

Magdoran said:
			
		

> Hello Margaret,
> 
> Sorry, when I read my post (28) on this thread, it occurred to me that my comment on discussing diagonals was ambiguous… I did actually mean I was happy to discuss these with you in the public forum, but with some limitations… I didn’t mean I won’t talk about these at all, just that some of the things I do may not make complete sense without all the reasons being addressed.  But the primary difficulty is in constructing good scenarios…
> 
> ...



Hi Mag,

I do understand if there are some things you would prefer not to discuss on the forum - there is no problem there.

As you asked for suggestions on how this subject might be addressed, perhaps discussing a historical trade - either a real trade that has been closed out or one that would have worked in hindsight.  This would give a bit more insight as to the general nature of the trade, (eg. width between strikes, how many months apart, IV, what the underlying was up to, etc) without disclosing any of your current trades.  

As I've said before, I am only intrigued with these diagonals as I’ve had trouble finding them with a good risk to reward on the Aussie market probably due to the lack of large IV skews.  The exception would be in times of very low IV where it might be possible to get one on for a credit.

I have posted a screen shot of the Hoadley graph where you can see the imputs – can you see anything that I might have missed?  The lower dark blue line is the time line at July expiry and is at $128 profit with no change to the 35.1% IV.

To put this another way at July expiry – assuming $31.50 and 35.1% IV:
Buy-to-close July $28.50 short calls @ $3.00 x 1000 = $3,000 (all intrinsic value)
*Value of Aug $31.50 long calls @ 1.286 x 2000 = $2,572 (could you check that you get the same theoretical value?)
= $428 loss
Add in initial $550 credit
= $122  profit (close enough to Hoadley's $128)

If you agree with the above calculations, might be worth checking with Hubb to see if any settings need adjusting.  I have read of others who found OG wasn’t calculating correctly, but Hubb seemed to have an answer to it – can’t remember any specific details and I don’t own OG.

Hopefully we can find out where the discrepancy is…

Cheers,

Margaret.


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## Magdoran (18 July 2006)

sails said:
			
		

> Hi Mag,
> 
> I have posted a screen shot of the Hoadley graph where you can see the imputs – can you see anything that I might have missed?  The lower dark blue line is the time line at July expiry and is at $128 profit with no change to the 35.1% IV.
> 
> ...




Hi Margaret,


Not sure what's going on... this kind of difference I've found is common since all you need is one variable or an error somewhere to get different results...  

Which is why knowing what a spread should look like is so important, so you can intuitively recognise when something doesn’t look right and correct any errors.

Here’s the current graph – seems to line up with yours.  Sometimes the graphs can change a lot depending on the model settings – OG’s pretty reliable, but getting one variable wrong can really change the outcome.  

Also, I do remember fiddling with that graph to make it look right, but I can’t remember what I did, so have a look at the one below for comparison (our models still might be different, so expect some differences).


Regards


Magdoran


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## sails (18 July 2006)

Hi Mag,

Your new graph has narrowed the differences considerably so it looks like it may be to do with the settings in OG as this is the only thing you may have changed.

Cheers,
Margaret.


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## Magdoran (18 July 2006)

sails said:
			
		

> Hi Mag,
> 
> Your new graph has narrowed the differences considerably so it looks like it may be to do with the settings in OG as this is the only thing you may have changed.
> 
> ...




Hi Margaret,

May well be, I did kind of push it around that day now that I think about it... bizarre what you can do when you stuff around with the settings, isn't it?


Regards


Magdoran


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## wayneL (18 July 2006)

Magdoran said:
			
		

> Hi Wayne,
> 
> 
> I’ve had a look at your position, and put myself in the place of someone in this trade – now, this is not financial advice, but this is what occurred to me if I was trading in this situation, and what I’d tend to do…
> ...




I have three scenarios in mind for this.

1/ Creep backwards i.e a gap fill. This is my favoured scenario as it requires me to do nothing.

2/ Creep up/sideways. Would require some morphing/superimposing strategies over the top of this one in the way of more written front month options.

3/ The stock flies to $50 and beyond. I think this is the least likely.

The next few sessions will be crucial in determining the course of action. But fore the moment I am happy to do nothing.

The only thing I am not happy about is the initial analysis (the mistake with the software) as I would have done something a bit different... but que sera sera.


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## ducati916 (27 July 2006)

.FHAHH quote   
6.20  +0.70 +12.73% 
Open 6.200 Open Interest 14,856 
Bid 6.400 Previous Close 5.500 
Bid Size 251 Volume 1 
Ask 6.400 Day's High 6.200 
Ask Size 212 Day's Low 6.200 
Strike Price 40.000 Days Until Expiration 24 
Expiration Date August 19, 2006 

FHAAJ quote   
2.20  +0.20 +10.00% 
Open 2.250 Open Interest 14,429 
Bid 2.150 Previous Close 2.000 
Bid Size 40 Volume 48 
Ask 2.350 Day's High 2.250 
Ask Size 285 Day's Low 2.200 
Strike Price 50.000 Days Until Expiration 178 
Expiration Date January 20, 2007 


How are you thinking currently?


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## sails (27 July 2006)

Wayne, I think your original trade is currently close to break-even given the credit received when opening the position.   Anyway, remember this?  LOL



> Murphy's Law
> Section 34,
> Subsection 13,
> paragraph (c),(iii) states that:
> ...


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## ducati916 (29 July 2006)

What's the latest thinking? 

.FHAHH quote   
6.50 unch  
Open NA Open Interest 14,861 
Bid 6.800 Previous Close 6.500 
Bid Size 294 Volume NA 
Ask 6.900 Day's High NA 
Ask Size 79 Day's Low NA 
Strike Price 40.000 Days Until Expiration 22 
Expiration Date August 19, 2006 

.FHAAJ quote   
2.40  +0.20 +9.09% 
Open 2.400 Open Interest 14,384 
Bid 2.400 Previous Close 2.200 
Bid Size 838 Volume 26 
Ask 2.500 Day's High 2.400 
Ask Size 10 Day's Low 2.400 
Strike Price 50.000 Days Until Expiration 176 
Expiration Date January 20, 2007


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## wayneL (29 July 2006)

sails said:
			
		

> Anyway, remember this?  LOL




Ahahaha! Yes indeed. Anyway I've been like a one armed bricklayer in Beirut with all my blog nonsense, Sory I haven't kept up to date with this.


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## wayneL (29 July 2006)

ducati916 said:
			
		

> What's the latest thinking?
> 
> .FHAHH quote
> 6.50 unch
> ...





I remain mildly convinced we end up out of the danger zone by august expiry. (But seeing as Margaret has invoked Murphy's Law, we are now gauranteed to close at around 46-47 come 19 Aug LOL) I haven't made the sold option adjustments I mentioned, but have been delta hedging with stock as mentioned somewhere above. This has been working well enough to keep this mildly profitable. 

I'm giving myself 6/10 for this trade so far... no more.

I'll try and keep this updated.


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## sails (29 July 2006)

LOL Wayne - Murphy needs neither invoking nor inviting...
but he does have to stand aside when Lady Luck arrives


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## ducati916 (12 August 2006)

What's the latest thinking?




.FHAAJ quote   
2.40  -0.05 -2.04% 
Open 2.500 Open Interest 14,478 
Bid 2.300 Previous Close 2.450 
Bid Size 31 Volume 58 
Ask 2.350 Day's High 2.500 
Ask Size 10 Day's Low 2.400 
Strike Price 50.000 Days Until Expiration 162 
Expiration Date January 20, 2007 

.FHAHH quote   
7.30 unch  
Open NA Open Interest 14,669 
Bid 6.800 Previous Close 7.300 
Bid Size 249 Volume NA 
Ask 7.000 Day's High NA 
Ask Size 126 Day's Low NA 
Strike Price 40.000 Days Until Expiration 8 
Expiration Date August 19, 2006 

jog on
d998


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## ducati916 (19 August 2006)

Expiry today as far as trading goes [Saturday is the last day for being exercised]

So how has it all working out in the wash?
.FHAAJ quote   
2.85  -0.35 -10.94% 
Open 2.850 Open Interest 14,619 
Bid 2.850 Previous Close 3.200 
Bid Size 472 Volume 5 
Ask 2.950 Day's High 2.850 
Ask Size 201 Day's Low 2.850 
Strike Price 50.000 Days Until Expiration 155 
Expiration Date January 20, 2007 




.FHAHH quote   
8.00  -0.50 -5.88% 
Open 8.000 Open Interest 14,590 
Bid 7.800 Previous Close 8.500 
Bid Size 111 Volume 3 
Ask 8.000 Day's High 8.000 
Ask Size 41 Day's Low 8.000 
Strike Price 40.000 Days Until Expiration 1 
Expiration Date August 19, 2006 

jog on
d998


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## wayneL (19 August 2006)

I'll have to tally it up when its all over. 

I'm keeping the long calls for now and I have been dedging delta with long stock so have to work it all out.

I think the actual option strategy will finish with a small loss.

I'll be away from my main computer till tuesday so will do a post mortem next week...

I thought this was going to kick into the profit zone at the last minute, but alas I've run out of time.

Overall with the long stock, a profit, but not well executed.

Cheers


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## ducati916 (19 August 2006)

That's fine, I'll look forward to reading the post-trade analysis.

jog on
d998


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## Magdoran (1 September 2006)

Hello Wayne,


So, what was the final outcome of this trade?  How did it end up, I’m curious?


Regards


Magdoran


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## ducati916 (1 September 2006)

*et al* 

And while we while away the hours, a little Options strategy that requires a rigourous risk analysis;

*Buy long dated Option [11mths expiry]
*Sell short dated Option [1 month expiry]

Rationale;
Bought call cost $3.40 with 11 months expiry = $0.31/per month/cost
Sold Call @ $0.40/higher [income] provides arbitrage profit of $0.09/month
[not including expenses in this example]

So, based on this scenario, what is a rational way to assess the risks?

jog on
d998


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## wayneL (1 September 2006)

Magdoran said:
			
		

> Hello Wayne,
> 
> 
> So, what was the final outcome of this trade?  How did it end up, I’m curious?
> ...




The strategy is still going as I'm still long the $50 calls.

I'm still to do the paperwork, but as an overview if what transpired after the gap.

I had a choice of superimposing a ratioed strangle over the top or delta hedging by buying stock if it looked like moving higher. My view was that it would dribble back to ~$40 before expiry, so elected not to do the ratioed strangle.

That view was wrong and had I have done the strangle, the strategy would have finished in profit with no further action.

The contingency plan was to delta hedge with stock if the underlying started heading north which it did on 24th July. These trades pushed the overall strategy into modest profit by August expiry.

I held the $50 calls and these are going well.

Scoring myself: 

Initial implementation - 3/10 due to the mistake in calcs

Management 6.5/10 - It's gone reasonably well but not without a degree of luck. Should have done the defensive strangle. This would have been more in keeping with the goal of the trade.

Should have been done completely differently.


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## wayneL (1 September 2006)

ducati916 said:
			
		

> *et al*
> 
> And while we while away the hours, a little Options strategy that requires a rigourous risk analysis;
> 
> ...




Duc

The risks lay in the difference in gamma between the front month option and the back month. This means the strategy has the potention to develop unwanted delta if the underlying moves too far away from the strike price.

There is also a potential vega risk. If IV drops, your back month long option will drop in price and you will get less premium on the front months. This coulsd also work in your favour as well.

It's a good strategy in the right circumstances but some management could become necessary if the underlying starts moving.

Cheers


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## dutchie (20 September 2006)

G'day Wayne,Sails & Magdoran

I was wondering what the best way would be to start plotting implied volatility for a share (ASX).

1. Use the ATM Call value at the e.o.d. for the current month?
2. Get the volatility value from the ASX site ? or 
3. Get the last price of the ATM Call option on the day and put it into the Black-Schooles formula from Hoadley site and work out the IV?
4. I know different strike prices would have different IV's but as a average value (especially to compare the changes of IV day to day) the ATM value is the best bet?
5. Would it be better to plot the average of the last "x" days?
6. When it was close to expiry date would it be better to jump to the next month?

Cheers

Dutchie


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## sails (20 September 2006)

Hi Dutchie,

I just use WebIress and find it generally matches up OK with Hoadley.  There is the occasional unrealistic spike that shows up but if it's only one day, I don't put too much weight on it, but find it is good enough for my needs.  It shows if IV is at it's extremes and which way it is trending.

There are some free demos of WI around that have IV charts - http://www.traderdealer.com.au/clients/clients.php
http://www.morrisonsecurities.com/int_trading.htm

Just type the code + IV (eg BHPIV) into the code field on a chart and you can choose from daily, weekly, monthly, etc time frames.  I see that htmlIress also has IV charts available - it's an alternative if you have difficulty in loading up WI.

Cheers,

Margaret.


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## Magdoran (20 September 2006)

dutchie said:
			
		

> G'day Wayne,Sails & Magdoran
> 
> I was wondering what the best way would be to start plotting implied volatility for a share (ASX).
> 
> ...



Hello dutchie,


Implied Volatility (IV) is a tricky beast.  How you determine how to use it depends a lot on what you’re trying to achieve, and what your preferences are since there are many different ways to look at it.  Wayne, Margaret, NetAssetts, and other contributors will all have their own approach to how they interpret and use IV.

Model:
Determining which model you use can also make a difference in some cases, a lot again depends on what you’re looking at. I use Binomial/American exercise for the ASX, but have to set the number of steps to around 25-30 or else my PC chugs (Have 2 gig ram, and 32 HT etc and it still chews up the cpu if set to 50 steps).  

Black and Scholes has some distortions in the model, which become evident with some calendar spread value returns which are incorrect, so just be aware of this.  Also, Black and Scholes was designed for European exercise hence it returns values that doesn’t take into account the theoretical added value for American exercise.

IV:
IV average is exactly that, the average for all the strikes at different levels and expiries, so it can be a little misleading to use it as your benchmark in many instances.  Also note that dividends can move the IV for calls down, and IV for puts up nearing ex div.

I change the focus of my IV estimation depending on what I’m doing – which strategy I am looking at, what the time frame is, and what expiry time there is in the options I’m looking at, what the constituent parts are (calls/puts, ATM/OTM/ITM, & expiry).

For example, if you’re looking at long term options, and only calls, you may want to compare the 90+ IV averages, average IV for all calls, the overall IV average, and then compare the same strike in different months, and all the strikes in the same month.

I factor in where the current IV is in relation to the range in the appropriate time frame.  Say you expect to be in the trade for a month, you’d probably look at the current month, and maybe 3 months out.  If you expect to be in the trade for 0-7 days, you may only want to look at the current month.  Say you expect to be in a trade for 3 months, you’d probably look at the past 6 months.  

But this varies a lot depending on your judgement.  A lot depends on your view of the underlying, and the way that volatility is trending itself.  I actually think you can read volatility charts just like you can standard OHLC underlying charts, although how you look at them is a little different.  In a way you need to correlate the underlying movement with the respective IV movement.

I tend to ignore last prices, and focus on the model price, but this is a personal preference.  I look at the way the underlying is trending, and try to estimate where IV may move depending on future movements in the underlying.

Generally, strong down moves in the underlying tend to increase IV (sometimes significantly).  Strong up moves can too, but not always.  Small inside days and prolonged sideways movement in the underlying or gentle trends tend to see IV move down.  The expectation of news and rumours can make IV spike up, and when the item is known, cause it to spike back down again, depending on what the underlying does.

IV can differ for calls and puts for a variety of reasons.  Also, activity in the front months (less than 45 days time value) can really swing IV values around (more so in the US than Australia).  So, if you’re trading 60+ days, you may find the front month IV irrelevant to your strategy.  The core point is to find information that is relevant to what you are doing.

If you’re doing 2 or more legs, you’re looking for favourable skews where you want to sell higher IV and buy lower IV.  You want the later IV movement for your positions to move as favourably as possible. If for example you’re looking at low volatility entry spreads such as reverse ratio spread calendarised puts and calls as one unit (sell OTM lower number/ratio calls and puts in the front month, buy higher number/ratio of calls and puts in a later month closer to the money), volatility becomes critical.

But any of the approaches you suggested, or the ones I’m mentioning here, or the ones others may venture later, are all worth considering, and the more you trade, the more you’ll find approaches that work for you depending on your broader approach.


Regards


Magdoran


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## wayneL (20 September 2006)

For any of the un-dead who awake after sundown to trade the Evil Empire:

US Stock IVs

http://sigmaoptions.netfirms.com/IVcharts/stockIV.htm

Futures IVs

http://sigmaoptions.netfirms.com/IVcharts/IV.htm

Cheers


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## potato (12 January 2007)

for asx options traders, where do you get your volatility charts....


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## sails (12 January 2007)

potato, check out post #54 in this thread - that's where I get mine


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## potato (12 January 2007)

thanks sails, i was skimming this forum and didnt see it.


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## Fox (19 September 2009)

Hi Wayne, 

I'm trawling through old threads on volatility and stumbled across this one. There's so much for me and other newcomers, to learn from this thread. Unfortunately, the images in post #1 are no longer available (ie. appears as a broken link). Would you, by any chance still have them? If so, I would be very grateful if you can post them here again or refer me to a link where I can access them. Thanks, Wayne.

Fox.


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