Divide by Nought

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Dow Drops Below 9000

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Looking at a graph of DJI (or any other market tracking index—the Q’s and SPX are excellent examples) about 2 weeks ago it was about half way between its lows in 2002 and the highs in 2008.  Notable, but not enough to worry about, at least not in my opinion; even if only a few people agreed with me.

At the time it seemed very unlikely that the market would drop to the low point found in 2002.  Now it seems much more likely.  The question is, if it gets there will it stop?  If it doesn’t, how low do we go?

When the DJI plowed through 9000 today it really did plow through it.  It didn’t hesitate, at all.  Really, look at an intra-day chart, no hesitation whatsoever.  I was surprised to see that and would be even more surprised if that happened should we hit the 2002 low.  However, if it did happen I might reconsider the whole not-worried thing.

From a technical analysis perspective that makes the highs in 2000 and 2008 look a lot like a double top (especially on the S&P 500).  If we take that view on the DJI and measure the estimated end point it’s around 200.  That’s two hundred, not a typo.

A little less bleak (and much more debatable), there is an inverted cup and handle in there too.  It’s about 6 months in length.  I haven’t measured where the end point would be, but it’s a large enough pattern that it certainly doesn’t give me a warm fuzzy feeling.

All that said, I don’t think that’s going to happen.  I think if we come close to the low in 2002 we’ll find some support and begin heading back up; albeit likely a tumultuous and slow climb.


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Thursday, October 9, 2008 at 1:10 pm

Posted in Trading

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Volatility and Options Pricing

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For experienced traders this is a little slow, but there are some interesting points further down especially in the form of other things to look into.

For less experienced traders I think it’s worth adding one bit of information concerning the nature of volatility. I don’t believe this was mentioned, although often eluded to. That is, volatility, while having lots of definitions, is, in the end, the mechanism by which market makers control the prices of options.

All other factors (underlying price levels, greeks, etc) are simply byproducts of options pricing equations. This is somewhat like the Fed controlling interest rates in an effort to control the economy. They essentially have one big lever that they can move around and everything else falls out of that. Of course, in both cases there are other factors but volatility for market makers and interests rates for the Fed are the big guns so-to-speak.

What’s the point?

A few compelling quotes from Ron Ianieri concerning volatility that really get to the point of why one should care:

“What really makes an option an option is extrinsic value.” (An option with almost no extrinsic value essentially moves directly with the stock).


“The biggest components to extrinsic value is volatility.”


“Volatility is the most important component of option pricing.”


“When volatility increases all option prices increase” and vice versa.

A look at the differences in an option from the perspectives of a buyer and a seller.

  • same stock
  • same month
  • same strike
  • same interest rate (rho)
  • same dividend paid to both parties; if paid at all.
  • different opinions on the current volatility level.
    That is, one party (buyer or seller) thinks that 30% is high while the party (the buyer to a seller, or seller to a buyer) on the other side of the trade thinks that it’s low.

The Basics

There several kinds of volatility:

  • Historic; volatility of the stock for some historic period. Actual, factual, specific value.
  • Forecast; volatility that you believe the option will be at in the future.
  • Implied; volatility that can be determined by solving option pricing model for volatility at a certain price.

These are fin definitions but it’s worth noting that there are other more elaborate definitions of these terms out there. I’m paraphrasing from the chat.

Vega shows the price movement given a one tick (volatility is measured in percentages) movement in volatility. That is if the Vega is 0.08 and volatility moves up one point (i.e. from 30% to 31%) the option price will increase 8 cents. On the flip side, if the volatility moves down one point the price will decrease 8 cents.

Volatility affects all other greeks in an options price.

Volatility Skews

The discussion of Skew starts with a statement and a question. First, when you look at the historic volatility it can only ever be a specific value for a stock at a given point, because once the move occurs the volatility up to and at that point is factually known. Given that, why does a single month’s options have different implied volatilities if the stock can only move/trade at one volatility?

Term referenced: Log normal distribution

Vertical Skew / Volatility Smile

The question above is really concerning Vertical Skew. This is also referred to as the volatility smile (term to look-up: Kurtosis). Vertical Skew is created by implied volatility that is “pumped up” further away from the money in order to make the options worth selling further away from the ATM price. That is, moving the markets far away from the at the money strikes takes larger movements in volatility because the Vega for those options is so much smaller. Thus market makers essentially create the volatility skew by adding more volatility to options further away from the at the money strike which they have to do to compensate for low volatility sensitivity (low Vega).

Horizontal Skew / Volatility Tilt

Horizontal skew is the skew across multiple months. That is, front month volatility tends to be higher than back months. This is in part due to the fact that Vega is higher in the back months and thus market makers don’t need to make large adjustments to change the price of the option the desired amount for movements in the underlying or other expectations in later months.

Put-Call Skew

Corresponding options: a put and a call that share the same month and the same strike. This are synthetics or put-call parody. Theoretically these should be trading at the same price, but they tend not to, and that is the put-call skew.

Positive put-call skew: is when the call is valued higher than the put.

Negative put-call skew: is when the put is valued higher than the call.

Originally a negative put-call skew was created because the majority of options traders were long the underlying stock. In dealing with options the stock holder was looking to protect themselves by buying options and/or create additional income by selling calls. So simply by virtue of supply and demand calls sold for less and the puts cost more to buy.

Not covered in this chat, I’ve also heard a lot of discussion concerning a negative skew in anticipation of market crashes. That isn’t as an indicator that the market will move down, but due to the expectation that markets tend to crash down and gradually work there way up.

Put-call spreads can be used to create a edge in trades.

Positive and Negative Skew

How out of the money puts are trading in relation to an equally out of the money calls. This can be used as an indicator of market makers’ expectations of the direction of the underlying.

Positive Skew: Out of the money calls trading with higher implied volatility than the related out of the money put; that is both x points out of the money. This suggests that the underlying is expected to move up. This is often seen in comodities, where it is less likely to have a surplus, and more likely to have a shortage, driving the price up.

Negative Skew: …is the opposite, and creates an expectation that an underlying is more likely to have downward movements.

Those were the major points of the chat as I saw them. There was some further discussion of synthetics, etc. Those discussions are interesting, but better taken in the context of the actual discussions.

These are my notes from the Think or Swim’s Wednesday Chat held on March 12th. The main topic of the chat was Volatility as presented by Ron Ianieri. Check out the full thing here: http://mediaserver.thinkorswim.com/transcripts/2008/20080312.html

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Friday, March 21, 2008 at 11:56 pm

Posted in Learning, Trading

…and we’re range bound again, for the moment.

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January hurt a bit. I was bearish, but not that bearish, so, ouch. But you have to pick yourself up and take advantage of what that kind of move can do for you. In this case: high volatility and some nice juicy premiums. I’m a seller (even when I’m bullish) so I love high premiums.
One trade that was put on at around 33% volatility was this broken wing iron: IRON CONDOR SPY FEB 08 138/140/120/119 CALL/PUT. The box in the image below depicts when I got in, where expiration was, and the range that I wanted to stay within. A little iffy in the beginning of Feb, but it hung in the channel. Notice that there was more protection on the downside, so I certainly wasn’t thrilled on Feb 1st.

It’s not a killing, just good consistent income. The trade started with a 60% probability of success and the potential to yield a 30% profit, which it did. Not too bad.

I’m not a broker, and I don’t make recommendations…and this trade closed yesterday, so I suppose it’s a moot point anyway.

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Saturday, February 16, 2008 at 6:23 pm

Posted in Musings, Trading

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