Monday 11/2 Advanced Lab Notes

11/2/09
Discussion NOtes
Selling Implied Volatility in the overall market
Adv Trading Lab

The Premise:

~ IV (VIX) has spiked recently due to actual volatility in the market and the perception of risk.
~ There are key economic events in front of us this week (FOMC meeting and decision on interest rates and their role in buying treasuries.

The Strategy:

~ We will price and examine 2 different ways to short IV in the market.
~ We'll look at the inverted Calendar and a Short Strangle on the QQQQ.

Short Strangle

~ Delta Balanced, Gamma Negative, Theta Positive and Vega Negative
~ Sell 1 call and 1 put on the same stock in the same expiration month
~ Use options in the 3rd expiration month (January 2010)
~ We're looking to have delta balanced the distance from strike to stock price equal on both contracts and values relatively equal.
~ We'll only use 2-4% of our account in margin executing this trade
~ As we looked at the options pricing the put options were carrying more value and higher IV than the call options. This forced us into a difficult decision if we wanted to enter this strategy. Either we could accept the fact that the market was overpricing puts and enter the strangle with an equal 4 dollar distance up and 4 dollar distance down or we extend the put down a few more dollars to create an unbalanced strangle. Both decisions have their merits and when entering strangles there are always 3 things you're trying to juggle ~ distance from the stock price to the strike prices, the value of the contracts and the delta. In a perfect world all 3 would be balanced. If you have to sacrifice 1 then delta can go first.


Inverted Calendar Spread

~ Delta Balanced, Gamma Positive, Theta Negative, Vega Negative
~ Use the options with higher implied volatilities....usually put options.
~ Buy the front month option (as long as it gives you enough time to execute your trade) Sell a back month option generally 3 months out.
~ Keep your margin between 2-4% of your account
~ There aren't delta guidelines....use risk graphs and make sure the graph represents what you want to trade on.
~ This trade is dependant on IV dropping. As we ran a risk graph analysis factoring in time and IV changes if the IV on the Q's drops 7% then our breakeven points after 10 days would roughly be 40.50 and 41.70. That's only 1.5 % move in the stock. But if IV drops only 4% then our breakeven's are 39.80 and 42.50 so the stock has to move almost 3 %. If IV doesn't drop then the breakeven is 43.25 and 39.50.
~ So we have a trade dependant on IV. If it doesn't drop we won't win. But that doesn't make it a poor trade. The nice thing about the Inv Calendar is that there is limited risk in the trade. Even if the stock doesn't move anywhere and IV doesn't go anywhere you have a limited amount of risk.