Trading Options Volatility

[wayneL]

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.

 

[Mofra]

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

Very much appreciated.

 

[sails]

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.

 

[omad]

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.

 

[Magdoran]

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.

 

[wayneL]

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

 

[wayneL]

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?

30day SV is IVolatility.com's choice for it's charts. I like to plot various different lengths on my own charts.

2. How is the mean implied volatility calculated?

It is an average of front month IV's, actual IV ranges from ~50% to >100% on this stock in the front month, depending on the strike.

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

There are detailed instructions on plotting vol in Amibroker over on my forum, I will post here later.

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

As Mag said, the best risk reward for my view. This is where the strategy modeller is indipensable. You can put all sorts of variables in to see how they theoretically work out. By varying the ratio, or by other tweaks, you can skew these more to the upside or downside

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

These aren't normally adjusted at all because when the news comes out, there can be a huge gap with a crush in IV... no chance to morph. Thats why I construct these to be as risk free as possible.

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

Not all. The right conditions only show up once in while. I also sell premium over indecies and take directional trades. However volatility is ALWAYS considered first and foremost.

Thanks for the great post.

Cheers

 

[wayneL]

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:

 

[NettAssets]

Thanks for that Wayne,

Quite an eye opener for someone still taking baby steps.

John

 

[wayneL]

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);

 

[hissho]

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

 

[wayneL]

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

Hi Hissho

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

 

[wayneL]

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

 

[flyhigher]

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

 

[wayneL]

excellent stuff Wayne.

questions:
1) does the software use real-time data to give real-time volatility?

I use the real time prices and IV's fom my brokers platform and plot them into hoadley

do you have to stay up all night to watch it and catch an opportunity when it presents itself?

I am up trading futures and other option opportunities anyway

isn't it time-inefficient?

I spent about two hours finding, analysing and placing this trade. I think the time was well spent.

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

There are various combinations possible. Ivolatility IV is available free from CBOE for US options. There are various solutions available for oz...I'm probably not the best person to answer that as I don't trade OZ

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?

You won't find these particular opportunities on the big names. But there are still volatility opportunities, even on the big stocks. You can get a complete list of optionable stocks from CBOE.com

thanks a lot
hissho

Cheers

 

[wayneL]

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?

What I am doing is collecting very high short term premium and hedging my delta/gamma risk with lower volaltility, long term options.

In this type of trade, we must presume to back month volatilities will reduce as well. So it is important that the back month vols aren't too far away from normal values. In this trade, the back month at 31% is a pearler, they don't get much cheaper for this stock.

If the back months IV increased, it would be an absolute (though unexpected ) bonus.

I will re evaluate the trade at august expiry. The initial goal, is to exit the Jan options at that time, however if more opportunity exists by leaving the jan expiry on and creating a new spread, then I will.

2. Are premiums collected enough to cover the risk if stock stay 42-45 at the end of August?

Their is some risk of loss IF the back month IV collapses under 20% at around the $46 mark. Obviously, my view is that it won't go too much lower than it is currently.

thanks for your excellent example and sharing the knowledge.
cheers

No worries

 

[sails]

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

 

[wayneL]

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

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

 

[sails]

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

...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.

 

[Magdoran]

...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.

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