Saturday, November 10, 2012

Directional Trading With Options Pt2

Part 1 HERE.

In part one of this article, I stated that IF long option buys have any chance of outperforming straight out stock trading, it is the the "swing trading" time frame or momentum plays, generally moves that last 3 - 20 trading days. This is my opinion based on my experience and is not to say that one cannot be successful in other time frames, but let's just say my goal in option trading is outperforming stock trading over the long term; In other time frames, I doubt that the additional contest risk (extra brokerage and bid ask/spread in the notionally larger position size) and theta risk can be overcome by the advantages of gamma over the long term.

I m quite happy to stand to be corrected on this and I haven't done a scholarly thesis on this, but this matches the consensus of many other experienced option traders.

Firstly, lets look at the advantages and disadvantages of options versus stocks as I see it, always working with the assumption that an equal number of deltas is used, as described in Part 1

Stocks have the advantage of being very simple to trade. You buy x number of stocks and that is the number of deltas you have, you can calculate the exact profit or loss that is possible from a given move. For example if you want to acquire 500 deltas of x stock, you simply buy 500 shares, if your stock goes up $1 you have made $500, if your stock goes down $1, you lose $500 - easy.

However to acquire 500 deltas in x's options, some qualitative decisions must first be made. Obviously those deltas are positive so we are looking at calls, but am I going ITM, ATM, OTM? What delta is the option I want to buy - and why? If the delta of the option is .33 we're going to need 15 contracts to get our 500 deltas. Fine, but what expiry? How far out to we want to buy - and why?

How will these decisions affect the outcome of the trade.

Stop Loss
There is an advantage in a long option position that the absolute maximum risk is known, that is the cost of the options. Stock traders will protest that a stop loss order can be placed on a stock position, however that does not protect the trader in the event of a large gap. If the stock gaps down 50% overnight, there is no stop loss in the world that will save you. In addition, once the stop loss order is triggered, you are out of the trade; and how often have you been stopped out only to see the stock immediately bounce higher?

Although the maximum loss of the option position may or may not equate to the calculated loss of a stopped out stock position, a maximum loss on the option position does not necessitate the exit of the trade. If that stock bounces back hard, you may still be in the money.

Another advantage for the long option trader is gamma. This is the Greek that measures the change in delta as the stock price moves. If you are long the above calls, all things being equal, the position will increase in deltas as the stock goes up. So if that puppy is going in your favour, you have some automatic pyramiding of the position, and the higher it goes, the longer you get.

Likewise, if the position goes against you, deltas will decrease getting you less and less long as the stock moves down. The stock position never changes its delta however.

This is good news, the more gamma you have, the more accentuated this affect. There is a flip side to gamma though, which is...

Countering the positive effect of gamma, is theta (or time decay). Every day that you are in a long option position, you are losing time value on your option. Actually it is more complicated than that; the time value will vary in relation to the option's moneyness and volatility, but as a general principle it is true, an option devalues as time goes by.

Theta has a direct relationship to gamma, so the more gamma you have, so too the more theta you will have.

This is the prime reason I believe swing trading/momentum plays are the spot where long options may have an advantage over stocks; providing one makes intelligent choices regarding strike and expiry. You can acquire sufficient gamma to give you a real boost if you get on a strong move, yet not suffering to any great extent from the effects of theta.

Vega measures the effect of changes in volatility on the price of the option. Stocks don't have vega, so not a consideration. Whether vega is an advantage or disadvantage to a long option position is... well, it can be either and is not something to be ignored.

If you punt on some calls at what you think is the bottom of a big swoon at very high IVs, you will suffer some degree of premium sag if it starts moving your way, particularly if you buy OTM options and your position gets toward being at the money. You were right and you may be in profit, but it will be like having left the handbrake on.

It is possible to be right on the direction and still lose.

On the other hand, volatility tends to increase on down moves. Buying puts at low IVs can be spectacularly profitable if you catch a high volatility down move, because of vega.

These Greeks are all something to be considered when selecting strikes and expiries, or even whether to select a long option at all in a given situation, which goes back to the first point - Complexity.

These points I have only really touched on and there are deeper considerations to these Greeks, such as when and where their effect is greatest.

Part Three coming soon.

Sunday, September 16, 2012

Directional Trading With Options Pt1

There are several philosophies used in options trading; premium collection, volatility trading etc. But the one I want to focus on for a while is straight out directional trading.

Yet again there are several means to trade directionally, from straight out option buys, to vertical spreads, to just about any other spread you can think of.

All require some consideration of direction, volatility and magnitude (yes there is a difference) of the anticipated move, and hence the effect of the Greeks... or rather a quantification of risk and reward via the Greeks.

The simplest way to trade direction with options of course, is straight out option buys, but once more the decision to buy an option is more complicated than straight out stock. We are faced with dozens of alternatives in the form of strike, expiry and quantity of options relative to an equivalent stock position. Though we may attempt to ignore them, the Greeks will still quantify risk and reward.

Some options educators recommend long dated, deep In The Money options as a stock replacement strategy, with delta greater 0.7, yet some others recommend short dated, way Out of The Money options in some hope to hit the occasional home run.

I think it's kind of futile to make such blanket statements without knowing what it is the trader is trying to do. There are various styles of directional traders, from long term strategic traders, trend traders, swing traders and day traders. The trader's goal in taking a trade is going to be important in what strike or expiry he or she selects... or indeed whether an option has an advantage over the underlying; there is no point in complicating a trade for no advantage.

The successful stock trader will have a risk management and position sizing regime in place, so for any trade, a position size will be calculated. In option lingo terms, we can describe this as the number of deltas. As the share delta is 1.0, the number of shares will be the number of deltas exposure in the trade. If a long position size is calculated as 1000 shares, we have 1000 deltas exposure.

If we are considering replacing stock with options, that is also how we should view our directional exposure, by the number of deltas. For example, if we bought ATM options with a delta of 0.5, we would need 20 contracts to make up the equivalent 1000 deltas of exposure. DITM options with a delta of 0.7 would need 14 contracts to approximate the 1000 deltas and OTM options with a delta of 0.25 would require 40 contracts to do the same.

It is the with other Greeks where things get interesting and how we can define whether there is anything to gain... or lose from option buys. A stock position is not affected by these Greeks, so we know absolutely our profit or loss from a given move. However options are non-linear and profit or loss parameters exist a in a more chaotic system. We can know profit or loss within a range,with a given move in the underlying, but the randomness of volatility changes and time in the trade make the absolute results more variable.

An examination of each type of trading is beyond the scope of this article and it is my belief that if long options have potential to outperform stock trading, it is in the swing trading time frame or momentum plays, trades of 3 - 20 days duration.

That's the time frame I want to look at.

Part 2 HERE

Sunday, June 17, 2012

A Look At Covered Calls - 6 Months In

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing) with a non-margin account.


Although I haven't posted in a while and didn't update May results, I have been recording the hypothetical trades in real time. It is now six cycles with a bull phase and bear phase included. This has been fortuitous as it has been handy to show largely what I have been wanting to demonstrate about covered calls.

Going back to my original motivation for this simulation, it was to expose the nonsense of the ubiquitous advertising line that one could make 4-8% income every month from this strategy.

This simulation is not the perfect example of how everyone would trade covered calls, but by now shows the problems inherent in the strategy as a systematic income generation machine.

I should point out that I am not against covered calls in the slightest. I use them (or the pure version of the strategy, the short put) frequently when I want that particular risk profile. I have some long term holdings that I sometimes write calls over when I think it is appropriate, but never systematically every cycle.

The fact of covered calls is that they are optimally profitable when the stock moves sideways. They under perform their underlying market in strong up-trends and outperform their underlying market (though may still make losses) in down-trends. Over the long term they reduce volatility, but depending on the greater trend there is no guarantee that they will be outperform the underlying.

I do not believe picking and choosing tickers (systematically) works any better than picking and choosing underlying stocks in a trading system.

Several 'educators' try to rework the numbers by altering the moneyness of the options, most frequently by writing deep in the money. This increases probability of profit, which feels good to the investor who enjoys large numbers of wins, but dramatically reduces the maximum profit. It also dramatically increases the size of the (abeit fewer) losses as a proportion to the typical win.

It changes the nature of the equity curve, but not the ultimate expectancy. It's a bit like a martingale system. it feels like you have found the holy grail for a while, until you get run over by the proverbial steam roller.

OK lets look at the graphs of the individual stocks I am using along with the total list of trades with the last two month's trades beneath the screen split.

As at close of trading June 15 2012:

Goldman Sachs

After six months trading, an impressive run up, an equally impressive swoon, we are essentially back where we started with both the underlying and the covered call strategy. All we have managed to achieve is to reduce volatility.

But this is a classic illustration of how CCs under perform the underlying in up-trends and outperforms the underlying in down and sideways trends. 

National Oilwell Varco

NOV has not been that dissimilar to GS, excepting that the CC strategy has managed to augment our equity by 5.5% over the six months. That's not a bad result for a buy an hold investor, but a far cry from the 4-8% per month as claimed by the seminar clowns.

Freeport McMoran

FCX represents the most significant out-performance of the three stocks selected at ~7.5%, but really has only trimmed the nearly 9% loss on the underlying to 1%. If you are invested in FCX on a buy and hold basis, that is a significant achievement... and that 7.5% is cash you can use for a festive dinner with friends and family, or reinvest if you prefer, but still nothing like the "buy my $3,000 covered call course" promoters claim.

Yes some of the returns in individual months were 4-8%, but mostly at the cost of even greater returns from the underlying. In other words investors trying to pick uptrends to write covered calls would have been better off just buying the underlying.

However, there is still good times to write calls in up-trends. One can dust off their crystal ball and write calls  a bit out of the money at points where the underlying is overbought and likely to retrace or consolidate in the time frame selected (time til expiry).

As shown, they also partially hedge in downtrends. But the best use of covered calls is if you can see into the future and pick when your stock is going to go sideways.

Overall, a useful strategy for investors, but sub-optimal for shorter term traders.

Saturday, April 21, 2012

A Look At Covered Calls - Cycle 4 Round Up

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing) with a non-margin account.


I have now wrapped up cycle 4 of the covered call simulation and the results get more interesting, but not unexpected on my part. The motivation for this sim is the representation of easy money available through trading covered call. Although this is not a perfect example, it is generally representative of the ebb and flow of trading this strategy.

I've tried to represent an augmented version of CC trading, via rolling at times within the cycle, to pick up more premium if possible. Most times this works, but sometimes it screws up at we shall see below with FCX.

Let's start of with GS:

The stock is off 10% (relative to starting price in Dec 2011) and the cycle's movement is shown by the red box.

I was able to roll the calls dow, collect most of the original premium, plus the additional premium as it expired OTM. A 6.4% cash profit from the option premium. This is set against the 10% fall. Although the covered call outperformed buy an hold in this cycle, the covered calls still made an overall loss. Buy and hold over the four cycles is still outperforming covered calls at this stage.

FCX was the screw up for the month from a trading perspective. The stock is down just ~2.5% for the cycle:

This is CC manna; write calls get sideways movement collect the premium and buy a holiday to the Bahamas on the proceeds at the end of the cycle. But when this whipped down to around $36, I traded the April $40 calls for $36 calls (Which I neglected to record on the blog. Like GS above, it would have worked well if it lingered down there, but it didn't. It whipped back up again causing a loss when closing out ITM on the second lot of short calls.

C'est la vie.

Cash profit for the cycle 0.65%, less the loss on the stock and we are again behind a bit. Nevertheless, the covered call strategy is in front of the stock over the four months by an eyelash.

Lastly, NOV was down ~9% over the cycle:

I rolled this twice and closed the third lot as it was slightly ITM, getting nice chunks of premium from each resulting in ~5.6% cash profit. But like GS, the dumpage of the stock caused an overall loss for the cycle. Like GS, the covered calls are making gains on buy and hold, but after four months, buy and hold is still a few lengths in front.

The overriding point at this stage is that in a non-margined account, there is still no net cash income from the covered calls. That would be disconcerting for someone sold the dream of reliable cash income from covered call trading.

Wednesday, April 18, 2012

Accuracy Of Market Estimates of Volatility

In a couple of recent posts viz, Is It Better To Buy Or Sell Options? and Buy/Sell Musings & Volatility, I've been looking at the trader's bias of being a either a buyer or seller of options, or at least being nett short or long gamma.

The conclusion I have reached, for whatever that is worth, is that the decision generically boils down to volatility. That is to say that the trader must examine the volatility priced into the option, AKA implied volatility, and decide whether the price is at, over, or under the odds; or in option parlance, whether the option is fair value, over, or undervalued.

Some writers suggest a comparison to historical volatility, but I wrote in Buy/Sell Musings & Volatility that I thought that was naive and an inappropriate way of determining relative value. Implied volatility looks forward; it is the collective markets guestimate of the volatility it thinks will be realized in the future, in other words the market's view of correct value for that option. It is not definitive, cannot be definitive, because we don't know what will happen in the future.

Historical volatility is definitive however because it measures actual prices traded in the market place over a set of past data of the analyst's choosing. This can be any period, but most commonly over the preceding 20 or 30 days of data. For the purposes of this article I am going to use 20 day historical volatility as this represents the approximate number of trading days in one month.

The VIX is an index of near term implied volatility on S&P 500 options and is quoted according to a formula, to smooth out implications of impending expiry etc. Details and method of calculation are available from the CBOE at this LINK. Essentially it is recording implied volatility one month henceforth.

As I have stressed up til now, it looks at past data, whereas implied volatility looks forward and what happens in the next 20 trading days may be vastly different to what happened on the last 20 trading days, volatility wise. It does have it's uses however. It allows the analyst to examine the 'normal' range of actual volatility for an underlying instrument, how it's cycles, what has been its upper and lower boundaries under various market conditions etc.

Historic volatility has a further use. We can use it to measure how accurately the market forecast one month volatility by looking at the actual volatility realized in on month's time, via the historical volatility calculation.

Let's have a look at the S&P500 using VIX as proxy for implied volatility available at a given date and realized volatility one month later.

Click To Enlarge
As we can see in the above graphic, on the 1st of Feb the market overestimated volatility substantially, therefore we can say that on that date and with the benefit of hindsight, we would have been better to have been a seller of options, all other considerations aside.

Manipulating the historical volatility plot backwards by one month makes it easier to analyze by lining up the implied volatility with the volatility realized in one month later.

Click To Enlarge
In the data that we can see in this graphic, the market collectively forecast volatility correctly, finally, in about the third week of March. So we can say, again with the benefit of hindsight, that S&P500 options at that point were fair value, though it is only today, one month later, that we can say that.

The displaced historical volatility plot gives us the opportunity to view the implied volatility at any point in the past and also in toto, to see how well the market forecasts volatility over the long term. The graphic below shows, on SPX options at least, that the market tends to over estimate forward volatility chronically.

Click To Enlarge
That is it overestimates future volatility until it doesn't. Sellers at market tops get taken to the woodshed.

This evokes the 'picking up pennies in front of a steamroller' cliche for put sellers and synthetic equivalents (buy/write traders) and bull put traders. Put buyers who successfully pick tops score a big time try/touchdown/<or goal scoring nomenclature appropriate for your country> with the vega bomb that blew up in the seller's face. (With apologies for mixing metaphors there)

As intimated in the preceding paragraph, of course being short or long options is not the only consideration. Delta, gamma and theta also cohort the make the trade; or wreck it as the case may be. In markets swoons put buyers will be celebrating with festive dinners, Dom Perignon and Cuban cigars while quite obviously call buyers will be drowning their sorrows with rough red, despite being on the correct side of the buy/sell divide.

The overriding point here however is that market estimations of volatility aren't very accurate and I believe an edge can be obtained by being a better forecaster of volatility and I believe such analysis can help traders make better option trading decisions and not be stuck in a permanent buy or sell paradigm.

Sunday, April 15, 2012

Buy/Sell Musings & Volatility

In a recent post I was discussing the question of whether it is generally better to be a buyer or seller of options. My conclusion was that theoretically there is no inherent advantage in either buying or selling, if options are priced correctly; it depends on the situation.

The oft repeated mantra out there in options land is to sell when options are overpriced and to buy when underpriced. Wise advice, but of course the sixty four thousand dollar question is - when is an option overpriced and when is it underpriced?

Of course if you know your option theory, you'll know the great variable in option pricing is volatility, all other inputs being known definitively.

We can measure the volatility of the underlying by looking back over a set number of days and applying a formula to determine the statistical volatility over that time frame. This is also definitive, but unfortunately may bear no relation to the volatility realized over the same number of days henceforth.

This is the volatility option traders want to know, future volatility. As it lies in the future, it cannot be known. Therefore the market collectively makes a forecast of future volatility and prices options accordingly, hence the measure derived by a little bit of algebra, 'implied volatility'.

Some folks suggest comparing implied volatility to statistical volatility to determine over or under valuation. I say that's naive. As discussed, statistical volatility looks backward, but implied volatility looks forward and as I've already pointed out, the volatility realized going forward can be markedly different to the preceding period.

What the individual trader must therefore do, is to make a call on future volatility and decide whether options are fairly valued or not, according to his or her own projections. Statistical volatility may be a tool that can be used in this analysis, but ultimately he who guesses best, wins.

Of course there are other dynamics at play depending on the specific strategy which may sink or save any one position, but good forecasters of volatility have a huge edge.

In the next post, I want to have a look at how accurately 'the market' forecasts volatility.

Tuesday, April 10, 2012

A Look At Covered Calls - April 11 Update

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing) with a non-margin account.


Just as this market was getting so complacent (relatively) that I was starting to doze off a bit, it throws in a half decent swoon, startling me from my daydreams. Now I find that the stocks I follow... and the index itself at levels of time and price support, I find myself pondering upon some adjustments.

As my covered call stock sell off, the extrinsic value of the call options have reduced, my positive theta is now relatively less, and the positions have built up some extra deltas. I can buy them back at a profit and re-sell ATM again to pick up more premium or leave them to expire .

If indeed the market does get some support here and we get a bounce going into expiry, those extra deltas are going to help the overall position. On the other hand if the market steps of into the abyss, they're going to hurt.

Writing new calls ATM will bring in more extrinsic, reduce delta and will partially hedge downside. On the other hand it opens the risk of taking it once again on the intrinsic value of those short calls if the market bounces.

This introduces a new question: Does the systematic covered call writer want to be an analyst as well, or just write premium at points where he can get it most. If I hark back to the original idea of this, it was to show a hypothetical portfolio to collect premium. .

Well as it's a hypothetical account, it doesn't matter much and the idea is to see different scenarios in real time, so I did record some adjustments earlier.

With GS trading at 116.13 I bought back the April 125 call for 56c and sold the April 15 for $3.40

I also adjust the NOV position; with the underlying at $78.33 I bought back April 80 call for 57c and sold the April 77.50 for $1.32.