Category Archives: Volatilty Forecasting and Trading

Nokia sells units to Microsoft

On 09-03-2013 Microsoft MSFT, announced that it is buying the handset units from Nokia, NOK. Nokia stock moved up over 16 standard deviations on the news. The chart below is a daily chart of Nokia, the red bars show the price move in standard deviations. The line on the bottom is the IV/SV ratio, notice how the implied volatility rose dramatically in the days prior to the announcement, a signal that something was happening.

NOK 09-03-2013

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VIX Spike

On Tuesday August 27th, 2013 the VIX spiked due to escalating tensions in Syria. Below is a chart of the spot VIX and the VXX, which is the VIX ETF based on the short term futures contract. The blue line show the correlation between VIX and VXX.

VIX vs VXX 08-27-2013

FB Facebook after earnings

The chart below shows FB, Facebook stock following a better than expected earnings report. The move up the next day, July 25th, 2013 was over 20 standard deviations. Facebook closed on Wednesday at $26.51 and opened on Thursday at $33.54.

FB post earnings

Regime Change

Regime Change

No, I’m not discussing political leadership changes in a foreign country due to intervention or a coup. The term “regime change” also applies to the stock market.  The stock market goes through regime changes or shifts. What the term refers to is the state of the market in terms of its trend and volatility. The majority of the time, the market trends quietly upwards with low volatility. These periods of low volatility are interrupted by brief periods of rapidly falling prices and high volatility. Without delving into the underlying mathematics of the econometric models that calculate regime change, it can be summed up in simple terms to mean that about 85% of the time the market will trend higher with low volatility. We’ll call this “state one”. About 15% of the time the market will be in “state two” characterized by falling prices with high volatility. The trend is approximately three times as large in the negative direction when the market is in state two. Also, when the market is in state two, it tends to revert to state one quickly with 90% probability.

Ok, so what does this type of quantitative research mean to investors? What it means is that if you invest in the market you should expect most of the time to see your portfolio increasing in value with modest price swings, but also expect to have those quiet periods interrupted by brief periods of rapidly falling prices with larger price swings. Long term investors can use the periods of falling prices to add to market positions. Investors with a shorter time horizon, like those who are already retired can find the state two periods to be very unsettling. Investors can always consider using some sort of hedging mechanism if the volatility is causing too many sleepless nights. Index options can be used to hedge downside risk as can some of the new volatility and inverse ETFs.

What this can mean for option traders is that if we are in a period of high volatility, we can expect the market to eventually return to normal which means that the high volatility will eventually subside and we can expect to profit from strategies that involve selling options and collecting premium.

The Long Straddle and Gamma Scalping

The Long Straddle

The long straddle is a limited risk strategy used when the tactical option investor is forecasting a large move in the underlying or an increase in the implied volatility or both.

I don’t believe that traders should have a strategy bias. Traders should study the market and apply the strategy that best applies to their market forecast. Traders with a strategy bias tend to limit their opportunities.

However, I do think that it’s ok to have a few favorite strategies that you employ when you think that the time is right. One of my preferred strategies is the long straddle. For those of you unfamiliar with the strategy, the long straddle is the simultaneous purchase of at the money call and put. For example if XYZ stock is trading at $25, an investor would purchase the 25 strike call and put at the same time. The long straddle is a limited risk, theoretically unlimited profit potential strategy.

Why purchase a straddle? A straddle should be purchased when the investor forecasts a large price move in the underlying or an increase in implied volatility, or both. It is easier to forecast a move in the implied volatility than to attempt to predict price movement. One of the best times to put on a long straddle is in the weeks preceding a quarterly earnings report. Implied volatilities can have a tendency to rise in anticipation of the earnings numbers and peak out just prior to the announcement.

A straddle purchased before the volatility increase can be profitable. Generally they should be put on 3-4 weeks before the announcement, so they can be purchased when the implied volatility is low and appreciate in value as the implied volatility increases as the earnings announcement date is approached.

What are the risks associated with the long straddle? Well the implied volatility may not increase and the stock price may remain very stable. In that case, the enemy of the option purchaser, time decay or theta will take its toll on the position. You may also want to consider the volatility of the broad market before purchasing a straddle.  If the broad market has a very high volatility level due to some recent event, it may not be the best time for a straddle. If the VIX is at high levels you might want to consider another strategy. If the VIX is at normal levels or has declined and the investor is forecasting a rise in the VIX and a rise in the implied volatility of an individual equity due to an impending earnings announcement, a long straddle may be an appropriate strategy.

Is there any way to offset the effects of the time decay as measured by the theta? One tool that can be employed by aggressive traders is known as gamma scalping. When you purchase a straddle you have the right to buy or sell the underlying at the strike price. So, if you are long or short the stock in the same amount of shares as your equivalent number of straddle contracts, you have protection against an adverse move in your stock position regardless of whether you are long or short.

I like to do some scanning to find stocks with a history of implied volatility increase as the earnings date approaches. Then I use a 20-day window and try to locate issues that are trading near a strike price and at a 20 day moving average. I use soft numbers, so the entry can be plus or minus a few cents from either parameter. Then I calculate the daily standard deviation by dividing the annual standard deviation by sixteen.

Why use the number 16? The square root of time is used to calculate standard deviations across multiple time frames. There are 256 trading days in a year. The square root of 256 is 15.87, so that is rounded to sixteen.

So I have now entered my straddle when the price of the underlying is at a strike and near a moving average. My position is close to being delta neutral. The at the money calls and puts should have roughly the same delta. Again, I use soft numbers, so I consider a delta of -50 to +50 as being delta neutral. Because I have a long position it will be gamma positive, so that means that the delta can change rapidly with movement in the underlying and that I will profit from large price swings.

Once the option position is on, if the stock moves up by one standard deviation, I’ll short enough shares to make my position delta neutral again. If the stock moves down by one standard deviation, I’ll take a long position in the stock. Using round lots, I’ll buy enough shares to become delta neutral once again. When the stock returns to its mean, I’ll close the position for a small gain. Remember if the stock moves one standard deviation from its mean, there is a 68% probability that it will return to the mean. If it makes a two standard deviation move, there is a 95% chance that it will return to the mean.

By gamma scalping this way, the investor can attempt to earn day trading profits sufficient enough to offset the time decay of the position. When things go right, I have been able to earn enough day trading profits from this method to completely cover the cost of the straddle before it is liquidated around the time of the earnings announcement. I don’t have a hard rule for exiting the straddle. If profits are adequate from the implied volatility increase I may liquidate the entire position just before the announcement. On the other hand I may decide to sell part of the position and keep some through the announcement and try to profit from a large move in the stock. If the position has been paid for by gamma scalping on a daily basis along the way, the investor has a lot of flexibility with their money management strategy at the exit.

Alcoa P/L Graph

Alcoa Long Straddle P&L

TVIX, Two Times the VIX? Not Today.

Investors who followed the price action of TVIX today witnessed a great example of what can happen when using leveraged and inverse ETNs.  The TVIX is designed to give an investor twice the daily price movement of the VIX. If you want to place a hedge and think that volatility is going to rise, the TVIX should give you double the action of the VIX and make for a good hedge when IV is rising.

Today the VIX rose and TVIX got crushed. In February, Credit Suisse announced that it was not going to create any more shares of TVIX. As a result TVIX is driven by market forces and can trade at a premium or discount to its indicative value, like the NAV of a closed end fund. The last few days TVIX has been trading at a substantial premium to its NAV. Because Credit Suisse is not creating new shares the algorithm that allows it to track its index, the VIX could not work and the mass selling on very high volume brought the shares down to an all time low. Volume was more than two and a half times its three month average. Today’s fall was almost 30 percent. Yesterday it had closed over 80% above its indicative value at $14.43. Today it closed at $10.20.

When using any leveraged or inverse funds investors need to do their homework and know what they are buying and how to apply them to a trading or investing strategy. Before purchasing a levered or an inverse fund it is critically important to understand the structure of the fund. They have added risks. The funds are designed to move up by twice the amount of an index, or move up if an index declines or move up double or triple the amount an index declines on a daily basis. The key word here is daily. Over longer time periods they will not perform with double leverage. Due to  what’s known as ‘roll costs’ and after factoring in how daily market volatility works, the funds may not perform well over longer time periods.

You can own a leveraged index fund, watch the index gain over a long time period and see the leveraged fund decline in value. Here’s a real world example as reported by the SEC, the Securities Exchange Commission. Between December 1st, 2008 and April 30th, 2009 a certain index gained 2%. A leveraged fund that delivered twice the daily performance fell by 6%. During the same time frame an ETF seeking to deliver three times the daily performance of an index fell by 53%, while the underlying index gained about 8%.

Before using a leveraged or inverse fund, check past price action to see if it is performing as it should relative to its index. Check the fundamentals of the issuer for changes to its credit rating or if they have suspended issuing any new shares.

ETNs can be great tools for portfolio management, but one must understand the risks.

TVIX vs VIX 3-22-12

2 Minute chart of TVIX vs VIX

Forecasting Volatility

Forecasting volatility; With all of the different types of volatility, you may find yourself wondering how and why one should have a forecast of future historical or implied volatility. Most investors spend their time trying to forecast the direction of the market or of an individual stock. Followers of the buy and hold “random walk” theory know that the market has a strong upside bias over long time periods and will buy low cost index funds and hold them indefinitely. Most investors will buy a stock thinking that over time it will appreciate in price and maybe pay some nice dividends along the way. Technical analysts will devote time to studying charts, looking at things like moving averages, stochastics and other indicators to attempt to forecast a future price or at least the direction of the price in the future. Fundamental analysts will study earnings reports, the trend of the reported earnings and use things like PE multiples and book values to determine the future value of a stock. Most investors devote the vast majority of their analytical efforts in studying company reports or charts of past price action to determine the future price of a stock or index. So why would anyone be interested in forecasting the future volatility of a stock?

The first reason is that the volatility of a stock or index generally has an inverse relationship to its price. That is because prices have a tendency to fall faster than they rise. So, if the volatility is increasing, the price is usually declining and if the volatility is falling, the price is generally rising. So, if we could forecast volatility accurately, that would also tell us something about the likely future direction of the stock. There is a great deal of statistical evidence that stock prices do follow a random walk. In other words the current price reflects all of the known information about the company and there is no correlation between past prices and prices in the future.

The second reason is because volatility can be possible to forecast. When analyzing volatility we do find that there is a serial correlation between returns. Volatility has a tendency to manifest itself in clusters. If you look at a chart of price of a stock it goes up or down and may show signs of trending predominately in one direction or another, but the price movements are random. If you study a chart of the volatility of a stock you’ll immediately notice that there are distinct periods of high and low volatility and that the periods of high volatility are followed by periods of lower volatility and that the periods of low volatility are interrupted by high volatility periods. There’s a simple reason for the clustering of volatility. In the absence of significant news a stock may quietly drift higher for a long period of time. If some news like a potential lawsuit, a product recall, or a new product announcement by a competitor comes out, the stock may sell off quite rapidly until the news is fully digested by the investing public. These short term sell offs can be considered to be buying opportunities for investors wishing to accumulate shares of the stock. When we chart the volatility of the stock these news events will show brief spikes in the volatility that typically persist for short periods of time, then return to normal. At times like this the future price direction may not be simple to forecast, but the volatility can be because it is a very good assumption that the volatility will eventually revert to the mean or return to a more normal level. The tactical option investor will utilize periods of high volatility to produce more income or do some share accumulation.

 

Option volatility and stock market volatility

Understanding Stock Market Volatility

I think that it’s important for option investors to have some understanding of basic statistics, especially standard deviation and lognormal distributions. Many option traders use volatility trading, that is they don’t trade by forecasting the direction of a stock price movement, but trade based on a forecast of the volatility. I closely monitor the volatility or standard deviation of the equities and ETFs that I trade.  Basically, there are different types of option volatility that we evaluate. Historical volatility is the standard deviation of the past history of the underlying.  Future volatility is what the volatility will be going forward, typically the period that is the life of the option contract. If the underlying has been through a period of low volatility you may expect it to rise, if it’s been through a period of very high volatility you may anticipate the volatility will quiet down for awhile and consider limited risk strategies that will capitalize on lowering volatility.  The option investor will study the historical volatility to help determine what may happen with the future volatility. Another type of volatility is forecast volatility which is a forecast of what the future volatility might be. GARCH (generalized auto-regressive conditional heteroskesdasticity) models and GARCH variants can be useful tools for volatility forecasting. These three types of volatility are all related to the underlying instrument, the stock or ETF.  Another type of volatility is related to the option contract and is determined by consensus of all of the participants in the market place and is derived from the Black-Scholes options pricing model and that is the implied volatility. When looking at a quote of an option price, check the implied volatility of the option compared to the historical volatility of the underlying. Is it significantly higher or lower? If it is, check the news wire and see if there’s a reason for the pricing. If the implied volatility is high and you’re looking at a stock check to see when the next earnings release date is or if there’s a major product announcement or lawsuit pending. When I am considering entering an option position, I’ll check the implied volatility of the options under consideration. I’ll pay close attention to the relationship between the implied volatility of the option and the historical volatility of the underlying investment. I’ll consider the current standard deviation plus some longer term history of the range and trend of the volatility. In addition to looking at the current implied volatility of the option, I’ll also look the longer term history of the implied volatility of the options. I guess we could call that the historical implied volatility. Since the implied volatility is the current volatility priced into an option, when you trade an option you are essentially making a forecast of the future implied volatility. If you think that the implied volatility is too low and will rise you should consider a strategy that will profit from rising volatility, like a long straddle if you want to be direction neutral or delta neutral. If you believe that the implied volatility is too high and that the volatility will decline in the future you should use a position that will profit from falling implied volatility like a credit spread or iron condor or iron butterfly.

Implied volatility is the one element of the Black Scholes model that must be estimated. Implied volatility can be derived from the formula using the current market price. Options that have a high implied volatility will be expensive and options that have a low implied volatility will be considered cheap. In general we want to sell something that’s expensive and buy something that’s relatively cheap.  So if we’re bullish on a stock and believe that the stock price is reasonable, we’re willing to own it and we think that the option price is high due to the implied volatility, we may think it’s a good time to sell a put. If you’re bearish on a stock, believe that it is overvalued and think that the options are cheap due to low implied volatility an investor may wish to purchase a put. Conversely if you’re bullish and think the implied volatility is low you may want to buy a call. If you’re bearish and think that implied volatility is high you may want to sell a call.

 

Using the New Volatility ETFs

Understanding Stock Market Volatility and the New Volatility ETFs.

Volatility in the stock market is what makes investors nervous. Without volatility, though stock prices couldn’t rise. Volatility is defined as the standard deviation of stock returns. It’s the downside volatility of the market that causes fear.

A recent development in the rapidly expanding ETF universe has been the creation of funds that reflect different measures of market volatility. These funds can be an effective hedging tool against portfolio declines when used properly.

The most commonly referred to measure of market volatility is VIX, which is a measure of the implied volatility of option contracts on the S&P 500. The VIX is also known as the “fear index.” The VIX will have a high reading when market participants are fearful and be low when the market is strong and there is a sense of complacency.

There have been numerous academic studies done on using the VIX to hedge equity portfolios. Goldman Sachs did one that concluded that VIX options could be a very effective portfolio management tool for risk reduction.

So how can an individual investor use the VIX for portfolio protection? Not too long ago, an investor would have had to buy and roll call options on the VIX index. This process worked well, but one had to consider the time decay of the options and the term structure. VIX options are based on the VIX futures, so each month’s option series correlates to that month’s futures contract. Some months may be priced higher or lower than another depending on the outlook of market participants. A strategy of rolling call options could be difficult for individual investors to implement effectively.

Today, an investor who wants a hedge and who doesn’t want a short position or an option position with time decay can purchase shares of the volatility ETF, the VXX when it is near the low end of its historical trading range. The VXX can be held indefinitely, just like a mutual fund. Once the VXX position has been purchased, it is held until something happens to the market to increase the volatility. If the market gets spooked by bad earnings reports, poor economic data, or unforeseen global events like natural disasters, war, terrorist attacks, etc, the VIX will spike and profits can be realized from the VXX position which can help to offset declines in a long term portfolio.