vendredi 4 mai 2012
10 Things To Know About the VIX
Here is some introductory material on the VIX, based on common questions from investors:
Q: What is the VIX?
Anwser: In brief, the VIX is the ticker symbol for the volatility index that the Chicago Board Options Exchange (CBOE) created to calculate the implied volatility of options on the S&P 500 index (SPX) for the next 30 calendar days. The formal name of the VIX is the CBOE Volatility Index.
Q: How is the VIX calculated?
Answer: The CBOE utilizes a wide variety of strike prices for SPX puts and calls to calculate the VIX. In order to arrive at a 30 day implied volatility value, the calculation blends options expiring on two different dates, with the result being an interpolated implied volatility number. For the record, the CBOE does not use the Black-Scholes option pricing model. Details of the VIX calculations are available from the CBOE in their VIX white paper.
Q: Why should I care about the VIX?
Answer: There are several reasons to pay attention to the VIX. Most investors who monitor the VIX do so because it provides important information about investor sentiment that can be helpful in evaluating potential market turning points. A smaller group of investors use VIX options and VIX futures to hedge their portfolios; other investors use those same options and futures as well as VIX exchange traded notes (primarily VXX) to speculate on the future direction of the market.
Q: What is the history of the VIX?
Answer: The VIX was originally launched in 1993, with a slightly different calculation than the one that is currently employed. The 'original VIX' (which is still tracked under the ticker VXO) differs from the current VIX in two main respects: it is based on the S&P 100 (OEX) instead of the S&P 500; and it targets at-the-money options instead of the broad range of strikes utilized by the VIX. The current VIX was reformulated on September 22, 2003, at which time the original VIX was assigned the VXO ticker. VIX futures began trading on March 26, 2004; VIX options followed on February 24, 2006; and two VIX exchange traded notes (VXX and VXZ) were added to the mix on January 30, 2009.
Q: Why is the VIX sometimes called the "fear index"?
Answer: The CBOE has actively encouraged the use of the VIX as a tool for measuring investor fear in their marketing of the VIX and VIX-related products. As the CBOE puts it, "since volatility often signifies financial turmoil, [the] VIX is often referred to as the 'investor fear gauge'". The media has been quick to latch onto the headline value of the VIX as a fear indicator and has helped to reinforce the relationship between the VIX and investor fear.
Q: How does the VIX differ from other measures of volatility?
Anwser: The VIX is the most widely known of a number of volatility indices. The CBOE alone recognizes nine volatility indices, the most popular of which are the VIX, the VXO, the VXN (for the NASDAQ-100 index), and the RVX (for the Russell 2000 small cap index). In addition to volatility indices for US equities, there are volatility indices for foreign equities (VDAX, VSTOXX, VSMI, VX1, MVX, VAEX, VBEL, VCAC, etc.) as well as lesser known volatility indices for other asset classes such as oil, gold and currencies.
Q: What are normal, high and low readings for the VIX?
Answer: This question is more complicated than it sounds, because some people focus on absolute VIX numbers and some people focus on relative VIX numbers. On an absolute basis, looking at a VIX as reformulated in 2003, but using data reverse engineered going back to 1990, the mean is a little bit over 20, the high is just below 90 and the low is just below 10. Just for fun, using the VXO (original VIX formulation), it is possible to calculate that the VXO peaked at about 172 on Black Monday, October 19, 1987.
Q: Can I trade the VIX?
Answer: At this time it is not possible to trade the cash or spot VIX directly. The only way to take a position on the VIX is through the use of VIX options and futures or on two VIX ETNs that are based on VIX futures: (VXX), which targets VIX futures with 1 month to maturity; and (VXZ), which targets 5 months to maturity. An inverse VIX futures ETN, (XXV), was launched on 7/19/10. This product targets VIX futures with 1 month to maturity.
Q: How can the VIX be used as a hedge?
Anwser: The VIX is appropriate as a hedging tool because it has a strong negative correlation to the SPX – and is generally about four times more volatile. For this reason, portfolio managers often find that buying of out of the money calls on the VIX to be a relatively inexpensive way to hedge long portfolio positions. Similar hedges can be constructed using VIX futures or the VIX ETNs.
Q: How do investors use the VIX to time the market?
Answer: This is a subject for a much larger space, but in general, the VIX tends to trend in the very short-term, mean-revert over the short to intermediate term, and move in cycles over a long-term time frame. The devil, of course, is in the details.
vendredi 24 février 2012
Intrinsic or Extrinsic Value
One point not often discussed is the way in which options are
priced. The quoted option price is in reality the sum of two separate
components. These are referred to as the intrinsic and the extrinsic
portions of the premium. I think of these as steak and sizzle
respectively.
For example, let's say AAPL has closed at around $395. The January 390 call has 41 days to expiration and could have been bought for $18.90. Of this sum, $5 represents intrinsic premium and $13.90 represents extrinsic or time premium.
This is an important distinction because it is the extrinsic premium which is subject to time decay and change due to variations in implied volatility.
The intrinsic premium is subject to change solely due to changes in the price of the underlying security. There is no sizzle in the intrinsic premium; you can buy the option today, exercise it to buy stock, sell the stock, and pocket the $5. Of course, your trading career will not last long with that sort of trade, but my point is that the intrinsic premium has an easily calculable true value.
The situation with the extrinsic premium is quite different. The value changes not only with time to expiration but also with the constantly changing implied volatility. It is for this reason that an option trader must be very careful with this extrinsic component.
Depending on the specific option under consideration, extrinsic premium may represent all, a portion, or a trivial amount of the entirety of the option premium.
Another important concept is that of the "moneyness" of an option. An individual option can be classified in one of three categories of "moneyness:"
* At-the-money
* In-the-money
* Out-of-the money
At-the-money options by definition consist of a single strike price. Both in-the-money and out-of-the-money strikes usually contain several individual strikes within their groups.
In our example of AAPL, the at-the-money strike is the 395 strike. The in-the-money strikes consist of all calls with strike prices below 395 and all puts with strike prices above 395. The out-of -the-money strikes consist of all calls above the 395 strike and all puts below the 395 strike.
Obviously since the price of the underlying defines the category into which an option is classified, the category into which an individual option fits is fluid and changes dynamically with the price of the underlying asset.
The reason for taking the time to discuss in some detail this classification of "moneyness" is that there are important reliable characteristics of each type of option.
At-the-money options characteristically contain the absolute greatest dollar amount of extrinsic premium. In-the-money options have the least amount of extrinsic premium. Out-of-the-money options consist entirely of extrinsic premium, and therefore only contain sizzle . . . no steak can be found there.
Because the functional characteristics of these three categories of options differ, it is a basic strategy to combine options of different "moneyness" to achieve trades with the best probability of success and the highest risk/reward scenarios.
For example, buying an in-the-money call and selling an at-the-money call gives birth to a call debit spread, a high probability trade structure for the trader who is bullish in the underlying.
For example, let's say AAPL has closed at around $395. The January 390 call has 41 days to expiration and could have been bought for $18.90. Of this sum, $5 represents intrinsic premium and $13.90 represents extrinsic or time premium.
This is an important distinction because it is the extrinsic premium which is subject to time decay and change due to variations in implied volatility.
The intrinsic premium is subject to change solely due to changes in the price of the underlying security. There is no sizzle in the intrinsic premium; you can buy the option today, exercise it to buy stock, sell the stock, and pocket the $5. Of course, your trading career will not last long with that sort of trade, but my point is that the intrinsic premium has an easily calculable true value.
The situation with the extrinsic premium is quite different. The value changes not only with time to expiration but also with the constantly changing implied volatility. It is for this reason that an option trader must be very careful with this extrinsic component.
Depending on the specific option under consideration, extrinsic premium may represent all, a portion, or a trivial amount of the entirety of the option premium.
Another important concept is that of the "moneyness" of an option. An individual option can be classified in one of three categories of "moneyness:"
* At-the-money
* In-the-money
* Out-of-the money
At-the-money options by definition consist of a single strike price. Both in-the-money and out-of-the-money strikes usually contain several individual strikes within their groups.
In our example of AAPL, the at-the-money strike is the 395 strike. The in-the-money strikes consist of all calls with strike prices below 395 and all puts with strike prices above 395. The out-of -the-money strikes consist of all calls above the 395 strike and all puts below the 395 strike.
Obviously since the price of the underlying defines the category into which an option is classified, the category into which an individual option fits is fluid and changes dynamically with the price of the underlying asset.
The reason for taking the time to discuss in some detail this classification of "moneyness" is that there are important reliable characteristics of each type of option.
At-the-money options characteristically contain the absolute greatest dollar amount of extrinsic premium. In-the-money options have the least amount of extrinsic premium. Out-of-the-money options consist entirely of extrinsic premium, and therefore only contain sizzle . . . no steak can be found there.
Because the functional characteristics of these three categories of options differ, it is a basic strategy to combine options of different "moneyness" to achieve trades with the best probability of success and the highest risk/reward scenarios.
For example, buying an in-the-money call and selling an at-the-money call gives birth to a call debit spread, a high probability trade structure for the trader who is bullish in the underlying.
lundi 13 février 2012
The Three Most Important Things Affecting Option Pricing
Option pricing is affected by a number of well known variables. Once you have an option position in place, whether it includes calls or puts, that you bought or sold, there are only a few things that can affect the price.
1. Stock Price
This relationship is the simplest concept to understand. The fact that stock price impacts option pricing is obvious and the first concept that is usually understood by people new to options. Calls go up when the stock goes up. Puts go up when the stock goes down. If we are bullish we can buy calls or sell puts. If we are bearish we can buy puts or sell calls. (Important advice: you generally do not want to sell options without having another option or stock to cover it. This is called naked selling. As the saying goes “You can lose more than your dignity going naked.”) Using a combination of stock, calls, and puts we can build an almost infinite number of trades to take advantage of any imaginable trend. This is the power of options.
2. Time Remaining In the Option
It’s intuitively obvious that if you want to have control of something for a longer period of time it will cost more money. Just like that beach house down by the shore. Nightly rentals are going to be pretty expensive, let’s say $750 per night. However, if you want to rent for a week, it’s going to cost $4,550. And if you want to lease for the summer, it’s going to cost you $40,500. If you are one of those people who love the beach year round, you can opt for the one-year lease at $73,000 for the year. On the face, those number look pretty expensive. But, let’s break it down.
We can see that clearly the best deal is the one year option. This is similar to the concept of time value in options. Longer term options cost more over all, but they are cheaper.
This is one of the reasons why we recommend that you use protective options with a longer term. Personally, when I consider protective puts, I am looking at a minimum of 90 days. This gives me protection I need and the time to adjust my trade after the event passes.
As the remaining value of your beach house lease becomes worth less and less over time, so does that value of the options. And just like the time seems on your vacation, the value decays faster and fast as the end approaches.
3. Implied Volatility
For traders new to options, implied volatility is the most difficult factor to understand. There is no corollary to it with traditional equities like stocks or ETFs. However, it’s really a straightforward concept. Simply stated, implied volatility is a measure of the future risk.
I imagine implied volatility as the flame in hot air balloon. The bigger the flame the higher the balloon rises. Implied volatility increases and causes the options pricing to rise. When it cools off the balloon will fall. This is exactly what happens with options. Take the case of RIMM and its upcoming earnings. We are seeing a rise in options pricing that is not related to anything other than the anticipation that stock will move after earnings. This is a well-known and documented phenomena in stocks like RIMM. AAPL, ISRG, GOOG, and SNDK are also known for this. These stocks can make huge movements after an earnings event. This “risk” is what drives up the implied volatility and options pricing up and down. That behavior presents opportunities for options traders.
4. Risk Free Interest and Dividends
There are two other factors which affect options pricing: risk free interest rate and dividends. These are not ignored when we trade options. Generally, these factors do not change dramatically. Therefore, we tend to neglect them. But keep in mind, if a stock changes its dividend (e.g., BP?) or the interest rate changes (e.g., the FOMC ends its “For the Foreseeable Future” policy) you will see options pricing changes. We just do not see these changes very often.
I am writing this article because I often run into people who do not understand the concept of implied volatility. One time, I had a student have the light-go-on. He had the “aha! moment” and proceeded to tell me that “Sometime you run into things in your life and you say to yourself ‘I don’t understand that.’ And somehow you convince yourself that it’s not something that you really need to know and then you just move on. That is the way that I used to think about implied volatility.” That might be true for things like astrophysics or philosophy, but it’s not true for trading options.
The truth is that these three things are essential concepts to understand when it comes to trading options. Once you have your options trade in place, these are the most important factors impacting the value of your trade:
1. Stock Price
This relationship is the simplest concept to understand. The fact that stock price impacts option pricing is obvious and the first concept that is usually understood by people new to options. Calls go up when the stock goes up. Puts go up when the stock goes down. If we are bullish we can buy calls or sell puts. If we are bearish we can buy puts or sell calls. (Important advice: you generally do not want to sell options without having another option or stock to cover it. This is called naked selling. As the saying goes “You can lose more than your dignity going naked.”) Using a combination of stock, calls, and puts we can build an almost infinite number of trades to take advantage of any imaginable trend. This is the power of options.
2. Time Remaining In the Option
It’s intuitively obvious that if you want to have control of something for a longer period of time it will cost more money. Just like that beach house down by the shore. Nightly rentals are going to be pretty expensive, let’s say $750 per night. However, if you want to rent for a week, it’s going to cost $4,550. And if you want to lease for the summer, it’s going to cost you $40,500. If you are one of those people who love the beach year round, you can opt for the one-year lease at $73,000 for the year. On the face, those number look pretty expensive. But, let’s break it down.
| Term | Total Cost | Cost Per Day |
| 1 day | $750 | $750 |
| 1 week | $4,550 | $650 |
| 1 season | $40,500 | $450 |
| 1 year | $73,000 | $200 |
We can see that clearly the best deal is the one year option. This is similar to the concept of time value in options. Longer term options cost more over all, but they are cheaper.
This is one of the reasons why we recommend that you use protective options with a longer term. Personally, when I consider protective puts, I am looking at a minimum of 90 days. This gives me protection I need and the time to adjust my trade after the event passes.
As the remaining value of your beach house lease becomes worth less and less over time, so does that value of the options. And just like the time seems on your vacation, the value decays faster and fast as the end approaches.
3. Implied Volatility
For traders new to options, implied volatility is the most difficult factor to understand. There is no corollary to it with traditional equities like stocks or ETFs. However, it’s really a straightforward concept. Simply stated, implied volatility is a measure of the future risk.
I imagine implied volatility as the flame in hot air balloon. The bigger the flame the higher the balloon rises. Implied volatility increases and causes the options pricing to rise. When it cools off the balloon will fall. This is exactly what happens with options. Take the case of RIMM and its upcoming earnings. We are seeing a rise in options pricing that is not related to anything other than the anticipation that stock will move after earnings. This is a well-known and documented phenomena in stocks like RIMM. AAPL, ISRG, GOOG, and SNDK are also known for this. These stocks can make huge movements after an earnings event. This “risk” is what drives up the implied volatility and options pricing up and down. That behavior presents opportunities for options traders.
4. Risk Free Interest and Dividends
There are two other factors which affect options pricing: risk free interest rate and dividends. These are not ignored when we trade options. Generally, these factors do not change dramatically. Therefore, we tend to neglect them. But keep in mind, if a stock changes its dividend (e.g., BP?) or the interest rate changes (e.g., the FOMC ends its “For the Foreseeable Future” policy) you will see options pricing changes. We just do not see these changes very often.
I am writing this article because I often run into people who do not understand the concept of implied volatility. One time, I had a student have the light-go-on. He had the “aha! moment” and proceeded to tell me that “Sometime you run into things in your life and you say to yourself ‘I don’t understand that.’ And somehow you convince yourself that it’s not something that you really need to know and then you just move on. That is the way that I used to think about implied volatility.” That might be true for things like astrophysics or philosophy, but it’s not true for trading options.
The truth is that these three things are essential concepts to understand when it comes to trading options. Once you have your options trade in place, these are the most important factors impacting the value of your trade:
- Stock Price
- Time Decay
- Implied Volatility
- Gas Pedal
- Steering Wheel
- Brakes
samedi 21 janvier 2012
Options Trading Volume Continues To Grow
Despite mediocre global economic conditions and lower stock volume at some brokers, the leading options exchange (CBOE) reported some impressive numbers for 2011. We'll examine their numbers as a proxy for the entire option industry.
With the vast diversity of options in terms of hedging, speculation and leverage, it's not surprising to see this continued growth and increased popularity.
Overall, CBOE.com reported combined options trading volume of 1.20 billion contracts in 2011 vs 1.12 in 2010 (up 7%). Average daily volume was up 8% to 4.78 million contracts.
The real growth is in trading of Index, ETF, & VIX options — we've previously discussed the growing popularity of ETFs. 2 CBOE flagship products, options on the S&P 500 Index (SPX) and CBOE Volatility Index (VIX), both bosted all-time annual volume records.
CBOE ETF options volume in 2011 was up a whopping 22% over 2010. And VIX options trading (which actually is on the CBOE-owned Chicago Futures Exchange) grew an explosive 174% over 2010.
The many advantages of using options in a portion of your portfolio for any type of investor or trader continues to become more apparent year-after-year, which is seen in the increasing volume and popularity.
With the vast diversity of options in terms of hedging, speculation and leverage, it's not surprising to see this continued growth and increased popularity.
Overall, CBOE.com reported combined options trading volume of 1.20 billion contracts in 2011 vs 1.12 in 2010 (up 7%). Average daily volume was up 8% to 4.78 million contracts.
The real growth is in trading of Index, ETF, & VIX options — we've previously discussed the growing popularity of ETFs. 2 CBOE flagship products, options on the S&P 500 Index (SPX) and CBOE Volatility Index (VIX), both bosted all-time annual volume records.
CBOE ETF options volume in 2011 was up a whopping 22% over 2010. And VIX options trading (which actually is on the CBOE-owned Chicago Futures Exchange) grew an explosive 174% over 2010.
The many advantages of using options in a portion of your portfolio for any type of investor or trader continues to become more apparent year-after-year, which is seen in the increasing volume and popularity.
lundi 9 janvier 2012
Two Approaches to Trading Earnings
It has become common knowledge that implied volatility for affected options rises sharply as an earnings announcement approaches. The effect is especially strong when earnings are released just one or two days before expiration.
WELL-KNOWN EFFECT
Google represents one of the best examples. Its last four earnings announcements have generated at-the-money volatilities of 140%, 120%, 110% and 120% respectively.
But capitalizing on the rising volatility effect can be difficult when it is partially offset by rapid time decay close to expiration. Some positions will lose money if the stock barely moves, and time decay swamps rising volatility. Both distortions – time decay and rising implied volatility – are strongest at the very end. Investors who structure trades that profit from rising volatility often find that most of their profits accumulate during the final few days.
1. YOU COULD : WAIT UNTIL END
There are two very effective approaches to capitalizing on rising volatility before earnings. The first involves waiting until the very end and purchasing straddles or strangles for just a few hours then closing the trade before earnings are announced.
This strategy is effective for stocks like Google that experience the sharpest part of their volatility increase during the final few hours. Implied volatility for Google options has risen 40% on the last trading day before earnings during each of the last four expirations. An increase this large is guaranteed to offset time decay, especially for options that are purchased after the open on the final day.
OR YOU COULD : USE NEXT MONTH OPTIONS
The second approach involves purchasing trades that benefit from rising volatility using next month options that expire a few weeks after earnings. These options also are affected, but the distortions are much smaller. Because the trade is far-dated, time decay is much smaller, and the volatility increase is more subtle.
For example, next month at-the-money Google options experience an average increase around 50%. On the final day, it is common for near-dated options to trade at 140% and far-dated options to peak out around 35%. Both values represent a substantial increase from the more familiar range in the low 20s where Google options normally trade.
ADVANTAGES
Capitalizing on the more subtle far-dated rise in implied volatility is relatively easy, because it favors positions that normally suffer from time decay and benefit from large moves of the underlying stock.
Straddles and strangles are the most obvious example. These trades are best to own during periods of rising volatility. The earnings effect favors such positions by offsetting time decay with rising volatility. More important, it erases the falling volatility that normally accompanies a rally – a problem that often plagues straddle buyers during a bull market.
Some investors try to capitalize on falling volatility after earnings by selling volatility at the very end just before earnings are released. This approach is one of the most dangerous strategies in the option trading world. Google, for example, has moved much more than the amount priced into its options during three of the past four earnings announcements. In October, straddles doubled from $38 to $76. They likewise climbed from $28 to $48 during the July release and $26 to $49 in April. Very few strategies can lose this much money in such a predictable way.
Finally, some investors trade the falling implied volatility that follows earnings. This game is also difficult, because implied volatility tends to fall more quickly than the rate at which the stock calms down. Although it is counterintuitive, the falling volatility environment that follows an earnings release is often a good straddle buying opportunity.
Written by Jeff Augen
WELL-KNOWN EFFECT
Google represents one of the best examples. Its last four earnings announcements have generated at-the-money volatilities of 140%, 120%, 110% and 120% respectively.
But capitalizing on the rising volatility effect can be difficult when it is partially offset by rapid time decay close to expiration. Some positions will lose money if the stock barely moves, and time decay swamps rising volatility. Both distortions – time decay and rising implied volatility – are strongest at the very end. Investors who structure trades that profit from rising volatility often find that most of their profits accumulate during the final few days.
1. YOU COULD : WAIT UNTIL END
There are two very effective approaches to capitalizing on rising volatility before earnings. The first involves waiting until the very end and purchasing straddles or strangles for just a few hours then closing the trade before earnings are announced.
This strategy is effective for stocks like Google that experience the sharpest part of their volatility increase during the final few hours. Implied volatility for Google options has risen 40% on the last trading day before earnings during each of the last four expirations. An increase this large is guaranteed to offset time decay, especially for options that are purchased after the open on the final day.
OR YOU COULD : USE NEXT MONTH OPTIONS
The second approach involves purchasing trades that benefit from rising volatility using next month options that expire a few weeks after earnings. These options also are affected, but the distortions are much smaller. Because the trade is far-dated, time decay is much smaller, and the volatility increase is more subtle.
For example, next month at-the-money Google options experience an average increase around 50%. On the final day, it is common for near-dated options to trade at 140% and far-dated options to peak out around 35%. Both values represent a substantial increase from the more familiar range in the low 20s where Google options normally trade.
ADVANTAGES
Capitalizing on the more subtle far-dated rise in implied volatility is relatively easy, because it favors positions that normally suffer from time decay and benefit from large moves of the underlying stock.
Straddles and strangles are the most obvious example. These trades are best to own during periods of rising volatility. The earnings effect favors such positions by offsetting time decay with rising volatility. More important, it erases the falling volatility that normally accompanies a rally – a problem that often plagues straddle buyers during a bull market.
Some investors try to capitalize on falling volatility after earnings by selling volatility at the very end just before earnings are released. This approach is one of the most dangerous strategies in the option trading world. Google, for example, has moved much more than the amount priced into its options during three of the past four earnings announcements. In October, straddles doubled from $38 to $76. They likewise climbed from $28 to $48 during the July release and $26 to $49 in April. Very few strategies can lose this much money in such a predictable way.
Finally, some investors trade the falling implied volatility that follows earnings. This game is also difficult, because implied volatility tends to fall more quickly than the rate at which the stock calms down. Although it is counterintuitive, the falling volatility environment that follows an earnings release is often a good straddle buying opportunity.
Written by Jeff Augen
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