Archives of “implied volatility” tag

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The Heston Recipe

  
  Education
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Most traders are intimately familiar the implied volatilities of equity options. These implied volatilities are often smoothed to avoid the temporary spikes in the strike/maturity surface that can lead to butterfly and calendar arbitrage. Many trading desks and market makers use the Heston stochastic volatility model for smoothing.

To understand the genesis behind Heston model, and why it is so important, we must revisit an event that shook financial markets around the world: the stock market crash of October 1987. The consequence on the options market was an exacerbation of smiles and skews in the implied volatility surface which has persisted to this day. This brought into question the restrictive assumptions behind the Black-Scholes option pricing model, the most tenuous of which is that continuously compounded stock returns be normally distributed with constant volatility. A number of researchers since then have sought to eliminate the constant volatility assumption in their models, by allowing volatility to be time-varying. (more…)

Ten Reasons – Trading Long Option Strangles

  
  Education
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A long strangle is long one call at a higher strike and long one put at a lower strike in the same expiration and on the same stock. Such a position makes money if the stock price moves up or down well past the strike prices of the strangle. There are higher costs and risks with these strategies, as I discuss below. 

 Strangles are low risk plays, one side of the options will go up in value when the other side goes down in value the majority of the time.

  1. If one side becomes worthless it generally means the other side is worth a lot.
  2. You can make money on strangles even when you do not know which way the market will move.
  3. It is much less stressful to hold a position with a hedge in place.
  4. The big risks are transferred from the option buyer to the option seller in this play.
  5. Strangles lose small  with small movements but win big when there is a big move. The are asymmetrical in their construction.
  6. When one side of the option sellers blow up their account due to an outsized move you will be on the other side of them and be the trader their capital flows to.
  7. Strangles can be played on any time frame.
  8. With the strangles the winning side has a growing delta and the losing side has a shrinking delta.
  9. Strangles can be used to capture trends, volatility, and reversals.

Where is the risk? (more…)

10 Ways to Move From Peril to Profits

  
  Education
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  1. The first question to ask in any option trade is how much of my capital could I lose in the worst case scenario not how much can I make.
  2. Long options are tools that can be used to create asymmetric trades with a built in downside and unlimited upside.
  3. Short options should only be sold when the probabilities are deeply in your favor that they will expire worthless, also a small hedge can pay for itself in the long run.
  4. Understand that in long options you have to overcome the time priced into the premium to be profitable even if you are right on the direction of the move.
  5. Long  weekly deep-in-the-money options can be used like stock with much less out lay of capital.
  6. The reason that deeper in the money options have so little time and volatility priced in is becasue you are ensuring someones profits in that stock. That is where the risk is:intrinsic value, and that risk is on the buyer.
  7. When you buy out-of-the-money options understand that you must be right about direction, time period of move, and amount of move to make money. Also understand this is already priced in.
  8. When trading a high volatility event that price move will be priced into the option, after the event the option price will remove that volatility value and the option value will collapse. You can only make money through those events with options if the increase in intrinsic value increases enough to replace the vega value that comes out.
  9. Only trade in options with high volume so you do not lose a large amount of money on the bid/ask spread when entering and exiting trades.
  10. When used correctly options can be tools for managing risk, used incorrectly they can blow up your account. I suggest never risking more than 1% of your trading capital on any one option trade.

 

Why Traders Lose Money ?

  
  Education
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why13One of the most frustrating things a trader can experience is being dead on right about a trade, taking it, BUT.. still losing money! How can this be? This can happen in five different ways, each of the first four contain a lesson for better planning the fifth way to lose money in this list is just part of the game.

  1. You enter your trade correctly and it goes in your favor, BUT… you do not have the right exit strategy to capture your profits and they evaporate due to not having a trailing stop or waiting to long to exit to bank those profits. Sometimes winners even turn into big losers win not managed correctly. You have to have a plan to take profits while they are there.
  2. You enter the right trade BUT… at the wrong time, you either exit not allowing your trade enough time to work or you are stopped out but do not have a plan to get yourself back in the trade with the right set up. The right trade with the wrong timing pays nothing.
  3. You have the right entry and it goes in your favor BUT.. you pick the wrong stock option to express your trade. If you pick an option with a high implied volatility your trade has to overcome that vega priced into the option, after an expected earnings event that vega value will be priced out and you need the move in intrinsic value to make up that difference. With a far out in time stock option you need the price to move enough in the underlying in the time period of the option to make up the theta cost of time embedded in the option. It is crucial to understand the option pricing model to make the right option trades to express your time period and expected move. Sometimes options also do not have the liquidity in some stocks,or far out time frames, or far out of the money strikes. Getting in and out of an illiquid  option trade can be very expensive. (more…)

Implied volatility

  
Analysis, Education
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Implied volatility increases near the end of topping processes. This can be observed from VIX index. VIX shows relative strength despite the market keeps going higher. 

Implied volatility decreases near the end of a sell off. This can be observed from VIX index. VIX shows relative weakness despite the market keeps going higher.

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