Option Volatility Crush

Option Volatility Crush.

Trading option volatility movement is a fantastic way to receive a short time profit from a strategy. Earnings play is particular targeted for this style of trading. The benefit of trading over earnings is that option volatility increases substantially. If a trader sells premium shortly before the news event the theory is that the volatility will come back to mean. This movement creates opportunities, but is not without its risk.

Basically we are looking to take advantage of current high implied volatility compared to historical implied volatility.

The point of a news event is that something may happen and you do not know what the outcome is or will be. This unknown creates the volatility event that we are looking to capitalize on. At this stage because volatility is so high we are going to look at shorting premium. There are many ways of doing this, but we are just going to cover the event from a selling put perspective, as our outcome is that the company has a long history of solid performance and we expect for this to continue.

We are selling option premium, because if we buy options and volatility contracts as per what we expect we will lose money on the option. But selling options as the volatility contracts we can bank profits overnight.

Here are a couple of examples.

Note: It is important to only trade in highly liquid underlying, otherwise the bid/ask price may be too wide and hence the profits will deteriorate just on the spread. It will also give opportunities to enter and exit at ease.

Stock example 1

The stock was trading at $46.15. The day of earnings the short term options where trading at 127% volatility and the next month’s options were trading at 43% volatility. If we look at a 1 std deviation put option with a strike price of 40 the premium received is about 46.

The day after earnings the Volatility went back to 73 % the share price moved to 52.99 and the premium went to 0.05

Here is what the crush looked like using Interactive broker’s volatility lab;

Stock Code 2

The stock was trading at $58.25. The day of earnings the short term options where trading at 105% volatility and the next month’s options were trading at 51% volatility. If we look at a 1 std deviation put option with a strike price of 53 the premium received is 44.

The day after earnings the Volatility went back to 59% and the premium went to 0.13

Here is what the crush looked like using Interactive broker’s volatility lab;

Here is what the crush looked like using Interactive broker’s volatility lab;

Stock Code 3

The 3^rd stock is trading at $77.97    . The day of earnings the short term options where trading at 80% volatility and the next month’s options were trading at 26% volatility. If we look at a 1 std deviation put option with a strike price of 72.5 the premium received is Bid at 0.17.

The day after earnings the Volatility went back to 44% the share price moved to 78.30 and the premium went to 0.02

Here is what the crush looked like using Interactive broker’s volatility lab;

From these three simple examples we can quickly see the opportunities that lay in this style of trading if managed and done correctly.

Whilst the figures provided are as accurate as possible from the option bid/ask order screen there will be variances in data as prices leading up to these events can move rapidly, and the prices discussed here are probably not the best nor the worst. They are just what they are at the time of looking at the bid/ask for this article.

As with any style of trading, if you are looking to own the shares anyway, this strategy can be a good strategy to enhance your returns and if exercised you want to own the stock anyway. But for a pure options play, a trader needs to remember that if the news event is not in the traders favor, the share price will move against you and could move to a price that makes the volatility reduction value less than the share price movement and hence turn it into a losing position.

The Take Away;

Events which cause volatility to increase a significant amount above its mean, are a good time to get short premium in stocks. If you wish to own and buy into the stock, the extra premium will help enhance profits. If you are an option trader using earnings play and shorting premium, it can help increase profits, if the share price does not move much, and when you expect volatility to come back to its mean.

If you’re an options trader remember to trade small. It’s all about occurrences and managing your profits. The more occurrences a trader makes, the more stable your return will be from this strategy over the long term. When there is a profit on the table look at taking it at the earliest possible time, as the the trade is all about volatility contraction not how long you hold a option for.

Start Thinking Clearly with your Investing and Trading

Major General J.F.C. Fuller once wrote: “If we wish to think clearly, we must cease imitating. If we wish to cease imitating, we must make use of our imagination. Audacity and not caution must be our watch word.”

This can strongly be applied to trading and all forms of investing. How often do we spend time and a lot of money trying to imitate something or someone’s strategy for success?  How often do we fail when imitating someone else’s strategy? One of the main reasons is is because we do not really take the time to own it.

To be good at something is to get into the head space of thinking clearly. In order to think clearly we need to stop imitating and start using our imagination.

One of the biggest ways to think clearly is the ability to break it down. If you are modelling or imitating some, or someone’s strategy, break it down into language you respond to. As a general rule I break it down to the ridiculous and generally getting to that level, you will find out pretty quickly if you are imitating or learning from someone that can add benefit to your investing or trading. This in itself is how to stop imitating, as if someone is not aligning to where I am going, what my plans are, what I have trying to achieve, and what I am looking to learn, they then hold no value.

It is a great strategy to model someone else’s success and carve it out to make it your own, as modelling the right person and strategy will help you not to reinvent the wheel and give you a running start. But with investing and trading you need to be careful, as the internet and books are heavily sold in this field and yet most of them will not actually improve your trading, nor will you learn anything of real value. I have spent the last 20 years and lots of money, reading various books, buying various courses, and completing various training, and yet I can probably narrow it down to a very small hand full of books that are worthwhile. The rest are general in nature and do not really provide any benefit to the investor or trader.

This is where we go back to the quote, over the years I have talked to many different traders and investors and quickly realized how confused they are about whatever it is they are trying to achieve. I once went to a trader’s seminar association, and found out I was actually one of the small percentage of people in the room who actually trade and invest. I thought that was incredibly strange, but shows how people can be frozen in time because of information overload and no way to clear their mind and take action. I find they are wound up so tight, trying to follow a system or strategy down to the tee or trying to model something, or just trying to get their head around what is written (never mind what is written or taught could be absolutely wrong and they are trying to understand something that is wrong and/or makes no sense anyway), no wonder why people are confused. Then you have the overly paid sales men pushing something that is so complicated that if you lose money from a trade they can find a way and reason why that happened and what you did wrong. What a load of rubbish. But you need to be bigger than this, and move out of the “googling” and start using your imagination to come up with your next great investment strategy.

Once you have a clear mind you need audacity to make it happen and bring it together. With the daring and willingness, to challenge assumptions, and tackle the difficult and hard to do. If you don’t have a clear mind and the ability to think clearly, you will continue trying to imitate someone or some strategy without making it your own.

There is no silver bullet, and you will never find one, there are only thoughts and experiences. As an investor we need to realize this and move away from it emotionally and use our imagination on how we can make money from these thoughts and experiences.

So in short; Breakaway from everything emotionally, continue to read and learn, but remove yourself from any specific strategy and use your imagination to come up with your own investing technique and style. Make your strategy mechanical, practical, logical, well thought out and planned and then own it. Read, Learn, identify the takeaways that can help assist you in where you want to go, then implement those specific takeaways into your strategy. Once your mind is clear and you have it all clearly defined, take action with no delay and implement your new improved kick arse trading strategy.

Oil Seasonality Trading

Oil Seasonality Trading

Continuing the subject of oil we continue to look into it further. Onto seasonality. Using season is not definitive, but rather another tool to help identify opportunities and help make sense of the chaos.

If we look at the chart provided below we can see that the best time to buy Crude oil is February and Sell in August approx. Research has been provided by equity clock and they noted that if a trader has a buy date on the 24^th of December and sell date August 21^st, from 1990 to 2009 investors would have accumulated a return of 344% vrs a buy and hold return of 60% over that same time period. We will assume this data is correct.

Where we are looking into the data is where the 14 odd times noted in this blog page: http://novitytrading.blogspot.com.au/2015/02/can-oil-drop-30-barrel-and-go-to-20.html what time period where they I have noted that the low period of times where the market went beyond and made massive downside moves is from mid-November to end of December. This falls in line with the seasonal charts.

Looking back now at USO we can see that based on the seasonality there is a probability that this is the bottom.

Also looking at another ETF the RSX which is heavily geared to OIL has also made some sort of base and appears to changing its trend.

The Take Away;

If you are looking to get on the band wagon the best way would be to look for high volatility within options. Looking at the RSX the volatility has already come back as the market has been stable for about 2 months now and is steadily moving upwards now. A lesson to learn is to trade Volatility, if you were looking at volatility you would have been cashing in on the RSX over the last couple of months, at the same time looking at your risk as owning the RSX (Russian) market.

USO volatility is still high so good for selling option premium but one thing when trading the USO is be aware of the drag as the underlying is the futures contracts, where contango and backwardation will have an impact on the price. It’s a potential play but maybe another play is the futures contract. If going the futures contract and future options be aware of your notional value and don’t over trade because of the low margin.

Something to think about and add to the traders arsenal of goods to try to place and stack more odds in the traders favor.

Can Oil drop $30 a barrel and go to $20 a barrel?

Can Oil drop $30 a barrel and go to $20 a barrel? 

I have recently read an article from CITI Group on Bloomberg, noting that the Oil futures will drop down from the current price of approx., $50, down to $20 a barrel which “may soon be on the way”. This got me thinking, how did someone come up with this figure? Is it even possible and what are the probabilities of this event happening?

I put together some information;

Based on the current share price I have read that there is about a 3% chance that the oil futures will touch at $20 some point in the next 60 days.

I now then went over to the USO the oil ETF. This ETF is currently trading at $18.94. If I compare the futures and the ETF pull backs in 2008 I can see that the oil Futures market fell about 70% and the USO ETF fell about 81%. Pretty close to the same pull back. The article notes that the Oil futures is expected to touch $20 range meaning it needs an approx. pull back of 60%. This is similar to the 2008 pull back.

Without getting to technical as the ETF is not an exact replication due to “Drag”, but for this example let’s look what will happen. In this case the article pretty much expects that the USO ETF will trade down to about $8 give or take. Once again, there is no data on the exact formulas used and the best I could do is look at the last major pullback. So it’s not that accurate but you get the idea.

So what is the probability of USO ETF trading below say $8 in the next 60 days? Well I looked at a couple of things. One is the option volatility and this noted to me that there is a 99% chance the market will not touch $8 in the next 60 days. I then look at the history of the ETF and over the last 8 years the ETF has moved that amount 14 times within a 60-day time frame.

Based on Historical data if the ETF fell to $8 this is 57% pull back from current prices, based on the last 8 years of data and over 2000 occurrences the ETF has only moved that amount 14 times.

We will also need to note that the current Oil futures and Oil ETF market is already in a large pull back of about 55%, so we are expecting a further fall of another 60% from current prices. This would take the entire pull back in the vicinity of about 80%. Similar to 2008/2009 move and also the move in 1980/1986, but these moves were over a 9month time frame and a 6 years’ time frame. We are roughly 8 months into this move, so the timing is in line with the 2008 move, but we are years away from the 1980/1086 move. There is some cyclical action but that is beyond this blog.

The Take Away;

If you believe that oil futures are going to fall rapidly over the next short period of time, you should probably buy Puts like crazy. The probability of it falling in line with the Articles expectation is about 3%. This means you have a 97% probability that your expectation for the trade is going to be wrong. But that is not 100% and this is the market and there is always chance big moves can happen, as can be shown and noted above, it has happened before in history. Based on the information maybe the plays is going long, if there is this sort of move down to the $20 levels, or just wait a bit longer to avoid catching the falling knife.

Cost Basis Reduction Implementation through Options

Cost Basis Reduction Implementation through options

This article is trying to make it a simple explanation of selling premium to help increase profits and reduce a trader’s cost basis on a stock/ETF. Due to the numerous questions, this hopefully clears up some of them.

The benefit of using options is the ability to improve your cost basis when you wish to get involved into a particular share or ETF. What this means is the following;

When looking for investment opportunities the key to continually understand is that you can and probably are, wrong. Even though we do all this research and only go long at lows  (buying at the bottom) or selling when there has been a strong a rally (selling at the top) there are still a lot of times an investor is too quick with the trigger in getting into a stock or getting out.

Selling options gives the investor more opportunities to be right. And isn't that what we are trying to achieve. To be right more times than we are wrong. The trick is to be right more often but then also to ensure being right leads to more profit. I have a problem with a lot of people noting about statistical probabilities of a short option of being right, my main focus is to structure things to create profitable environment, not just selling premium to be right more times than wrong. As a trader/investor I would recommend you try to determine this to ensure you are happy with what you are trying to achieve.

Let’s go through an example; we can go over to the ETF RSX as a live example; RSX has been slammed in price mainly due to the ETF has substantial lean toward Energy stocks, and it has followed the oil sector over the edge. But looking at RSX chart a chartist can see it is forming a bottom of sorts.

Looking at this chart a chartist can assume that there is relative support at about $14. Can it go lower? Yes sure who knows right, Can it go higher? Yes sure it can, but wouldn't it be great if even if it goes lower we still make money. Let me put it this way, if when you buy a share outright the share can only go up or down. Simple, you either make a profit or a loss. But with and when selling a OTM  put option if the price goes up you make money, if it goes down (but stays above your strike price) you make money, and if it goes down below your strike price and you get exercised you start to lose money from that point, but only below any premium you have received. It really places the odds in the traders favor.

Let’s look at the example in further detailing;

Current RSX share price: $15.70

Put: Strike price of $14 Approx. 45 days’ time is selling for about $0.50. As options work in 100 shares this means if you sell an option you will receive $50 into your brokerage account.

Margin required to hold the Put options is approx.: $390

So what does all this mean, well it means that in 45 days’ time, if the share price is anywhere above $14 you have made $50. Based on the Margin of $390 this means you have received a return on your capital of 12% for 45 day period.  So to continue to clarify the stock has to fall from $15.70 to $14, an 11% drop and we can still make a profit. As long as it is above $14 we will profit from this particular section of the trade.

Now let’s move forward to the second section of the trade. Let’s assume the investor/trader did not “Roll Over” or close any of the option positions and wished to get assigned. Let’s re-look at the math; if the strike price is $14 and we have received $50 in premium already, our break-even is now $13.50. This means that at any point the stock is above $13.50 we are profiting from the combined trade of the option and stock value.

As an investor you must make sure this is the strategy you wish to deploy, as there are multiple different strategies within a strategy here, and you will need to assess your own risk if you wish to get the stock assigned or close the option or roll over. This is on a case by case basis and this article is not telling you to do it a certain way, but rather showing the math behind how to and where to get multiple profit opportunities by using options.

The trader also needs and should pay attention to Volatility as a high volatility within the option will ensure more premium is received, and this means more opportunities to gain more profits. Never forget Volatility.

As a Value investor using put options is a fantastic way to get involved into your stock at lower prices and continually reducing your cost basis on the stock. 

All options carry risk and the risk is that the stock could continue to fall to $0. This would mean a total loss of the share price times the amount of contracts you sold short. A trader can make their own risk calculations about the probability that can happen. When trading strong fundamental stocks and ETFs the risk is as close to mitigated as possible due to the research the trader/investor has put into knowing the company and business. But note that this comes at a price and the price is that most of the times Volatility is lower. Lower volatility means lower income premium.

To mitigate portfolio risk further it is always a good practice to keep your trade size smallish in relation to your portfolio. This will ensure that if the share is exercised you have capital to maintain the position you believe in as well as to continue to implement further cost reducing strategies, if your belief in the stock has not changed.