The Challenges of the Egotistical Trader

When one decides to trade for a living, they often immerse themselves in books and classes, spend countless hours on the internet doing research or perhaps talking to fellow traders. They learn technical analysis, computer programming, stock fundamentals, they study economic indicators. They search for patterns in things. They go with the trend, they fade the trend. In the end, very few of these people will ever be successful at trading. What's even scarier, is that when they fail, they often have no idea went wrong. Usually when people fail at something, they know exactly why. They might not have been able to do anything about it, but at least they know what it was that was their downfall.

But with trading, most people let their egos get in the way and they spend all their time trying to "figure" it out. The answer, the grail, the secret indicator, but they spend no time looking at themselves. Trading is really an endeavor into human psychology. When you understand how crowds think and how the behavior of the masses move the markets, it becomes much simpler to trade then all the indicators in the world.

Without going into a complete dissertation into psychology, I'm going to suggest you play a game. It's a very easy and simple game. This game will demonstrate to you the forces of human nature that are working against you when you are trading. The rules of the game are very simple. It's called the bargaining game. It requires two people. Try to pick someone as competitive as yourself. Here are the rules to the game. Both you and your opponent will bid for a $20 bill. You can bid whatever you want. Both you and your opponent are required to make at least one bid. You will flip a quarter to see who goes first. Now here's the catch to this game. Whoever the highest bidder is, gets the $20 bill. But, the loser has to pay his or her last bid.

So let's use an example here. Say I am playing Mr. X and I go first. I bid $1 for the $20 bill. Now Mr. X is required to make a bid. He obviously is going to outbid me so he bets $2. If we stop right now, Mr. X bought the $20 bill for just $2 and I have to pay out $1. Obviously it behooves me to make another bet so I bet $3. Now I am the highest bidder. Why did I make this bet? Because I immediately went from losing $1 to making $17. Now Mr X has just lost his $18 profit and now has a $2 loss. I don't have to tell you he is a little upset right now. So what does he do? He bids again, this time $4. Now he went from a $3 loss to a $16 gain and I am now in the hole once again.

I think you see where this is going. You see, it's always in our best interest to make another bet because we will be going from a losing bet to a winning bet and by doing so will be putting our opponent on the other end. What ultimately happens in this game is both players find themselves bidding more then $20 for the $20 bill. Well that sounds crazy doesn't it? Well, it is and isn't. To each player, he sees each additional bid as an opportunity to recoup his losses and put his opponent in the hole. For example, when I bid $30 for the $20 bill, it might seem stupid to you, but I am going from a $28 loss to now only a $10 loss. I am making back 2/3 of my losses right? Why is that not a good deal? Well, it becomes obvious why it's not a good deal when your opponent realizes the same thing and outbids you yet again. So how do we get out of this neverending mess? Well, it requires one of the players to swallow their pride and take a loss. But by doing so, you are letting your opponent of the hook. Most people have a very difficult time with this proposition. Because our ego gets in the way. We just can't take a loss and admit we got beat. So what do we do? We dig ourselves deeper and deeper in the hole.

So what is the optimal way to play this game then you ask? It's simple. If you lose the coin toss and are forced to make a bid after your opponent, you cut your losses immediately as you will realize that any further bets you make could bankrupt you. You are better off paying $2 for the loss and letting your opponent walk away with the $20 bill with a mere $1 bet. Yeah it's hard to do that, but it requires you to lose your ego.

Now I can see what some of you are saying. If I played that game for $20 I would be smart enough to give up after a few rounds and I would move on. Hell, it's only $20 right? Well, perhaps. But what if we changed it to a million dollars. That's right, you and your opponent now have the opportunity to bid for a million dollars. You could pay off your mortgage, your student loans, your credit card debts, travel around the world, live the good life. You can see the images in your head. I mean who wouldn't bet $1 to make a million. So of course you bet. But do you think your opponent is going to let you walk away with a million dollars! Not unless she has lost her mind. Now she is probably saying to herself, I'll bet, but I'll stop when it gets too high, say $500. So she bets $500 for the million and now you just lost all your dreams. Are you going to let this woman walk away with a million bucks while you are stuck paying out $499 in losses? And round and round we go. Now things get really ugly and you find yourself out of control losing everything.

This game demonstrates some of the obstacles every trader faces, his own ego. His need to be right. Many times we find ourselves in a trade unwilling to get out because we know we will be right eventually. We are unable to stop the losses from mounting, because doing so would require us to swallow our pride and admit defeat. But like the bargaining game, the optimal strategy is to just cut your losses and play the game again. Keep doing this until the game works in your favor. It's very hard for most people to see this.

This game by the way doesn't just apply to trading but in all sorts of facets in life. The game is taught to many people in college so they can understand the process of self destructive decision making. For example, take a couple who has been married for ten years. Things aren't going well and the optimal solution at this point is to separate. But one or both parties says to themselves, I can't leave now, I have invested too much time and money and energy into this, if I leave, all will be nothing and I will have to start all over again. The same principles apply here. Both parties stay together because they feel that they have past the point of no return and too much will be wasted if they split up. So what they do? They stay together in a self destructive marriage until one of them shoots the other.

What about somebody that starts a business? Same thing. They invest all their money, all their time, into something for years. At some point they realize the business is never going to work but they don't want to admit it. So they keep trying to make it work even though they are essentially caught in a bad trade. The idea of quitting, taking your losses, and starting all over is just too much for most people to bear. So they stay at it until the bank forces them to quit.

As you can see by the bargaining game, very few people have what it takes to see the fallacy of their own ways. We take pride in the decisions we make and we never want to admit we are wrong, or stupid, or ignorant, it's much easier to just keep playing. And as the trade continues to go against you and the losses continue to mount, you always are able to justify staying in. Just as the person in the $20 bill game justifies that by placing another bid they are essentially cutting their losses, albeit temporarily.

So what can we learn by this? We have to understand the importance of controlling self destructive behavior. Because in the end, even if we make perfect trades, if we let our ego get in the way, it's only a matter of time before we lose it all. So the next time you are out with a friend, pull out a $20 bill and let the bidding begin. This is how you will find out what kind of a trader you are. It could very well be a cheap education for you.

John

HOW DO OPTIONS TRADERS LOOK AT THEIR PORTFOLIOS

In this case, we will focus upon the options "Stepladder" report, generated by most options risk management systems. When managing a portfolio of options, it is inconvenient to think of them on an individual basis. Indeed, a commercial bank foreign exchange options trader may have hundreds or thousands of options positions with different maturities in his portfolio at any given time. In addition to his options position, the options trader will have cash positions as well. He needs a mechanism for describing the risk in the position at any given point in time and for a given underlying or spot rate.


There are three kinds of risk to which the options portfolio is exposed at a primary level: movements in the spot rate, convexity and implied volatility. We know that we can insure the local exposure of an individual option to small changes in the spot rate by delta hedging. We also know that the delta for an individual option will change as the spot rate changes because of the convexity inherent in the way the option's price reacts to changes in the underlying spot rate. This is given to us by the gamma. We also know that the option's value will vary with changes in the implied volatility the market assigns to a particular maturity and strike.

In the case of a foreign exchange option, we are talking about options on a forward. A forward obligates the buyer to exchange one currency for another at a pre-set rate for a particular delivery date. For example, a large consulting firm might enter into a contract on January 5 that pays it $10 million US dollars for delivery into its US dollar account for value February 2. They may want to lock in the current rate of exchange the market is using for February 2. If the spot rate is 1.50, this might imply a rate for February 2 of 1.5010. The difference, 0.0010, is called the forward premium. It is determined by interest rate arbitrage and it is sensitive to the difference between interest rates in Canada and the United States. The consulting firm sells US dollars for value February 2 at 1.5010 to ABC Bank. Then, on February 2, it must deliver $10 million US dollars into ABC Bank's US dollar account in exchange for which ABC Bank will deliver $15,010,000 Canadian dollars into the consulting firm's Canadian dollar account for value February 2, regardless of the prevailing spot Canadian dollar exchange rate.


A foreign exchange option is an option on a forward because it gives the holder the right but not the obligation to exchange, in this case, $10 million US dollars for value February 2 at a rate (or strike price) of 1.5010. If on February 1, the Canadian dollar is weaker than 1.5010 (i.e. the exchange rate is greater than 1.5010), the consulting firm can let the option lapse and exchange its US dollars at the prevailing spot rate for value February 2. (Note that the Canadian dollar has one day of settlement between the transaction and delivery). In this case, February 1 is the option's maturity date.

Because a foreign exchange option is an option on a forward, it is sensitive to changes in the interest rate differential, as well. The options dealer will generate a Stepladder report that looks like the following to characterize his portfolio's exposure to changes in the spot rate, assuming that the interest rate differential for all maturities stays the same and that implied volatilities stay the same. Spot is at 1.50. The report is generated over a horizon of one day. Profit and Loss (P/L), Delta, Gamma and Vega are all denominated in US dollars.

Spot P/L Delta Gamma Vega
1.5200 $67,256 $9,257,650 $3,240,445 $49,010
1.5150 $41,995 $7,111,889 $2,145,761 $46,789
1.5100 $18,554 $6,325,789 $786,100 $44,258
1.5050 $1,401 $4,976,111 $1,349,678 $37,337
1.5000 ($11,256) $3,120,556 $1,855,555 $36,112
1.4950 ($18,752) $125,778 $2,994,778 $32,145
1.4900 ($17,895) ($10,156,123)$10,281,901 $31,247
1.4850 ($15,443) $556,741 ($10,712,864) $34,125
1.4800 ($16,742) ($3,214,748) $3,771,489 $36,544

How do we interpret this Stepladder report? First, let's consider the fact that this report is generated over a horizon of one day. We know straight away that if spot stays at 1.50 without moving at all over the next trading day, we will have lost $11,256. This number is the time decay for the options portfolio. It includes the net change in value of all of the options in the portfolio attributable to their maturities being shorter by one day. It also incorporates any change in the value of the forward portfolio attributable to their maturities being shorter by one day. And it includes the cost of funding our positions. (If we borrow money to buy options, we must pay interest on these balances).

The position has a delta of $3,120,556 at a spot rate of 1.50. If spot trades higher, say up to 1.5100 over the trading day, the portfolio will get longer US dollars. We could dynamically rebalance the delta hedge of the portfolio at 1.51 by selling $6,325,789, making us delta neutral at 1.5100. Should spot subsequently dip back down to 1.5000, the portfolio will now be short $3,205,233 (the difference between $6,325,789 and $3,120,556). Buying back $3,205,233 makes us delta neutral again.


At the end of the day, we compare the P/L number implied by the closing spot rate (e.g. ($16,742) at a spot rate of 1.4800) to the spot trading P/L we have earned by dynamically rebalancing the hedge. Hopefully, the net number is positive.

There are different ways of reporting the gamma. In this Stepladder report, the reported gamma is the difference between the current spot position and the portfolio's spot position for a spot rate that is 0.0050 higher. It appears as if we are long an option expiring tomorrow with a strike somewhere between 1.4950 and 1.4900. We suspect this because of the discrete jump in the spot position by more than $10,000,000 between those two spot levels. It is offset by our short position in another option expiring tomorrow with a strike between 1.4900 and 1.4850, suggested by the discrete jump in the spot position of more than $10,000,000 between those two spot levels. This phenomenon is referred to as strike risk or pin risk. When we have two options expiring on the same day with similar but not identical strikes, it can be very challenging to manage the net delta position at expiry if spot is near either of the two strikes.

Finally, there is the vega. At 1.5000, if the Canadian dollar implied volatility curve shifted up in a parallel fashion by 1 vol (i.e. by 1 annualized standard deviation), then the portfolio would make $36,112, even if spot did not move. Of course, if spot is not moving, then we are more likely to see implied volatility move lower which compounds the portfolio's time decay problem.

Article courtesy of Chand Sooran

Straddles and Point Spreads

With the Superbowl one week away, office betting pools are in full swing. So are all the online betting sites. While the Superbowl brings in all sorts of weird and quirky side bets, like who will score the first touchdown and how many field goals will there be in the game, a majority of the money is still placed on the good old fashion line.

Currently, the line is the Patriots – 6 ½. It always amazes me that many people still think this line is a prediction of the final outcome. Well, for starters, for those of you that don’t follow football, it’s not possible to win in half points. So that should be one clue. And many times you will see even lines, meaning the spread does not favor either team. Clearly, the odds makers are not suggesting a tie are they?

No, the line is meant to measure sentiment, not the actual final margin of the score. Then people will always ask me, why would they do that? Why would the odds makers make a line that they feel is wrong, just to bet on sentiment? Well, the odds makers are trying not to bet at all. They are trying to actually create a line that if correct, will generate the most amount of two way action. If they can accomplish this, the casinos who take the bets, need not worry who wins the game and by how much, but rather they can collect the 5% juice, as it is called, from both sides. Juice is like a commission. Kind of the way a broker makes money on every one of your trades whether you make money or not.

So what does this have to do with options trading you begin to ask? Well, it’s important to understand that the same dynamic that is used in the prediction of sports lines, is also used in big events on option prices. Although many academics may disagree with the notion that option prices are attached to sentiment, rather then rigid quantitative pricing models, the truth is, it’s probably a little bit of both. I just chose to explore the idea a little further to help others gain a better understanding of option prices before a big news event such as FDA approval let’s say.

Many people always ask me, John, how do the market makers price these options ahead a major move, when they don’t know which direction the stock will go in, or how big the move the will be? The answer, like the odds makers in Vegas, is sentiment. Most MM’s have a general idea of the range of prices that the stock could trade up to or down to after the news, but the MM’s are not interested in making a bet on the outcome of the move, they are interested in the same thing as the casinos in Vegas for the Superbowl, they want to earn the juice or the spread on both sides.

How do they do this? By making the option prices attractive to both the premium buyers and the sellers at the same time. If the option prices are too cheap, everyone will buy them and cause the MM’s to have to take the other side which they don’t want to do. If the option prices are too expensive, everyone will be selling premium to the MM’s and again, the MM’s will be making a huge bet that they rather not make. So the MM’s move the option prices accordingly to get the most two way action. This allows them to stay delta neutral and more importantly, gamma neutral ahead of a large and unpredictable move.

Now this creates an interesting situation. As the option prices may not reflect anything near what the final outcome will be, but rather just what the public feels the outcome will be. For the options speculator, this can create very profitable opportunities to bet against the public and reap huge rewards.

For example, during the past year, the option prices on all the FDA stock events have been substantially undervalued. People would ask me, well why then are the option prices not more expensive, don’t these MM’s ever learn? Actually, the MM’s made out very well I’m sure because the prices, which may have been undervalued, created enough two sided action.

Even if the MM’s knew how just how much a given stock would move on such news, if they priced their options accordingly, they would be so high that most of the public would be net sellers and no one would be buying. If the MM’s were wrong, not only would they lose their shirt, they would lose their seat on the exchange and probably their house and their life savings. No risk is worth that.

So the option prices traded far below their eventual fair value to accommodate the sentiment of the market place. Just as the line on the Superbowl will probably not be accurate as to the final score, it will bring in enough action on both sides to keep the casinos in business and allow them to fight another day. The only question is now, which side are you going to take?

John

Is It Possible To Make Money With No Risk?

Is it possible to participate in the upside of a long term bull market while having absolutely no risk to the downside? Why yes, it is possible. In fact, not only is it possible, but the product that makes this possible happens to be one of the more popular investment vehicles pushed by brokerage houses across the country.

Although each brokerage house calls it something different, these instruments are universally called Equity Linked Notes or ELN’s. Lehman Brothers calls them SUNS (Stock Upside Notes). Merrill calls them MITTS (Market Index Target Term Securities). Salomon Smith Barney has ELKS (Equity Linked Securities). Goldman uses the term SIGN (Stock Index Growth Notes). And last but certainly not least, UBS has SIRS (Stock Index Return Securities).

So what exactly are these magical investment vehicles? Well the brokerage industry needed to create new products after many people left the big wire houses for smaller do it yourself shops. And even many turned to Direct Access Brokers where they could actively invest and trade their account for minimal commissions. So in order to lure the public back in, these magical investment vehicles were created.

What they are is a combined fixed income and equity product. They offer a guaranteed return of your initial capital no matter what happens in the market. And if the market roars higher, you get to participate in most of the upside. Of course your broker will charge you a hefty fee for this service. On top of the 2% he gets for managing your account, there are usually sales fees on top of that and in some cases maintenance fees as well. Not to mention you have to pay taxes on what you do make. And to top it off, the investment firm even takes a small slice of the profits. They usually set a level in the index where you start making money. Of course they earn the spread between the current level and that high water mark.

So are these things really worth it? The answer is maybe, but certainly not with all the fees and taxes you have to pay to your broker. Being that the Chicago Options Traders group is full of very intelligent people and are very resourceful, we can make these things ourselves without all the added fees and to top it off, do it in a way in which we don’t even have to pay taxes on it.

So how do we do this? Well first of all, let’s reveal the secrets of what this really is. The first thing you do is buy a zero coupon bond. You can buy these in increments of anywhere from one year to 30 years with 10 years being the most common. A zero coupon bond is just that, it has no coupon attached to it. So you do not receive an interest payment every 6 or 12 months like you normally would if a coupon was attached. Instead the bond is sold at a discount to the future value of that bond. Then at maturity, the bond will be worth par.

One thing to remember is even though you don’t actually receive an interest payment, you will have to pay taxes on the imaginary interest each year. Unless of course, you do one of two things, execute this trade in an IRA account or a 401k plan or buy zero coupon municipal bonds, most of which are exempt from both federal and state income taxes.

So now we removed the tax element and the fee element. Now let’s add the second ingredient. That is instrument you want to participate in the upside in. It might be an index like the SP 500, or the QQQQ index. Or it might be an individual equity or possibly a group of equities. Perhaps create a power index with the likes of GOOG, EBAY, AAPL, TASR, and SIRI. You can do whatever you want, that is the beauty of it. Then what you do is buy long term leap call options in the index or stocks. Say you choose the SP 500. You might want to buy the JAN 07 ATM leaps or perhaps buy the ITM leaps to be a little more conservative. Where are we getting this money you ask? From the discount on the zero coupon municipal bond we purchased. Let’s say we buy a 20 year zero coupon municipal bond for $20,000. This bond may cost us $6,757. That would represent a yield of 5.5% a year and the tax equivalent yield could be as high as 7.5% So now we take the difference between $20,000 and $6,757 which is $13,243 and invest it in our long call leap options. If we buy the Jan 2007 calls we will have to roll them over then and perhaps buy the Jan 2010’s and so on.

The idea is, if the market trades higher over that period, you sell the leaps for a profit and then roll them to the next contract and keep doing this until the 20 years are up. One of two things will happen. If the market traded higher, you will have earned a nice return on your long SP 500 trade plus you will have the full maturity of your $20,000 bond. If the market crashes or goes no where over that 20 year period, you will have 100% of your capital returned to you when the zero coupon bond matures.

Of course technically in this example, you will have lost some money in opportunity cost. Had you placed the $20,000 in a treasury security, you could have earned the yield on that bond over the 20 years. But if the bull market continues to push forward over the next 20 years, your long call leap options will most definitely outperform any fixed income product and most equity products as well. And the best part about it, you do this with no fees on your total assets and you did this tax free. Of course you will have small commissions to pay every three years or so but it will not be 2% of your assets.

So there you have it. Now with all the money you are making trading options, you can siphon some money away in a retirement account and let it grow without the risk of blowing your retirement. Not that it would happen to any of the members of the Chicago Options Traders Group. Of course this goes without saying, but this post is in no way a recommendation for investment nor am I giving financial advice in any way.

John

The Relationship Between Volatility And Time

In previous articles we have compared products with linear payoff profiles to instruments with non-linear payoff profiles and we learned that only non-linear products have time value. We talked about the true meaning of time value to a derivatives professional and the question he must ask himself when evaluating a particular structure.

"If I buy this structure, will I be able to make more money trading the underlying cash instrument than I will pay in time decay over the life of the instrument?" (Conversely, he could have asked himself, "If I sell this product, will the losses I sustain trading the underlying cash instrument against this structure be less than the premium I am paid at inception?").

Let us restrict ourselves to the question facing the prospective buyer of this non-linear instrument. Think of it as a call option on a particular stock, say Dollar.com. For the purpose of argument, assume that the current stock price is $100, our option's notional amount is 100 shares, the options matures in 3 months and the strike price is $100.

In evaluating this central question of value, there are two important factors that stand out: volatility and time. We will consider them one at a time.

The higher the implied volatility of this product, the higher the premium will be and the more difficult it will be to pay for the option. However, if we expect actual volatility to be higher than the implied volatility, it may pay for us to own this option and to trade GE stock against it.

The key here is our expectation of what volatility will actually turn out to be as it relates to the implied volatility.

For example, if implied volatility on our Dollar.com call is 15% (on an annualized basis) in the marketplace but we think that actual volatility will be closer to 25%, we should buy the option. We will make more money delta-hedging the option (or rebalancing the delta in response to market movements) than we will pay in premium. See previous articles for an explanation of delta-hedging.

Now, what does it mean if implied volatility for our option in the marketplace jumped from 15% to 25% immediately after we bought our option. This might happen if there was an unexpected announcement from a takeover company, Savage LBO LLC, that they were going to make an unfriendly bid for Dollar.com. The outcome is uncertain.

First, we will see the premium jump higher for the option we own. We will own something that has increased substantially in value. Because the option is at-the-money spot (i.e. its strike is equal to the current spot rate), this effect is at a maximum. Recall that the change in the option's value due to a change in implied volatility, all other things being equal, is its vega.

Second, we can see that the 3 month call we bought at an implied volatility of 15% is now worth what a 6 month call with the same strike before volatilities shot up in response to the announcement. Therefore, the move higher in implied volatilities is like an extension of our 3 month option into a 6 month option. It is as if we got 3 months for free.

Time value is the measure of how much money we should make if the stock turns out to be as volatile as the implied volatility says it should be. Changes in implied volatility necessarily mean changes in time value (and therefore premiums). We could make the same absolute amount of money delta hedging a short-dated option on a very volatile underlying as we could on a long-dated option on a calm underlying.

Article courtesy of Chand Sooran

Next Meeting Monday, January 24th

This is just an early reminder for our next meeting which will be Monday, January 24th at 7pm at the Belmont Public Library. We will be having our first guest speaker Dan Sheridan.

Dan was a 22-year CBOE market maker with and Mercury Trading where for the past 17 years he served as senior trader, trainer and risk manager. A dynamic presenter, Dan regularly teaches traders and retail investors on behalf of the CBOE’s Options Institute.

Since leaving the pit in 2004, he has mentored individual traders on the techniques and methods he used everyday to consistently profit in the options markets. He has previously provided training and commentary to numerous organizations including Mercury Trading, First Options, the Mexican Stock Exchange, DePaul University, Jon Najarian’s TCB Radio program, and WCIU TV 26 (Chicago).


Topics Dan will cover during this Special Presentation:

How do Pit traders buy and sell options ("THE PHILOSOPHY")

How to create an options portfolio to bring in monthly income

How to find stocks with big potential moves

Strategies that can significantly increase your yield in your retirement account

How to read the tea leaves of option volume

The Pit Traders Secret: How to successfully play stock earnings

Repair Strategy: How Pit Traders repair bad stock and option purchases for little
or no dollars

A great low risk, low cost, high yield spread to bring in monthly income

Managing the risk of the iron condor

Yes Virginia, Options Are Risky

Equity options can be risky. At least that’s what we are obligated to tell little Virginia when she asks. But we would be doing her a terrible disservice if we left it at that. We owe it to her and to ourselves a little better explanation.

The concept of risk is one that very few people in this world understand. Take this guy, we’ll call him Bill, that says he doesn’t smoke because smoking can potentially lead to lung cancer. Instead of smoking, he prefers to drink, and quite heavily at that. Occasionally he will even get behind the wheel of a car after some heavy drinking. But he doesn’t smoke. Nope, that would be too risky.

Or what about Tom, who refuses to put money in the stock market. You know, because the stock market is risky and it could crash, and you could lose all your money. Tom of course has no inhibitions about buying a house that recently tripled in the last 5 years. No, much safer investment.

What about Susan, who is afraid of flying. You know, the plane could crash. It could be hijacked. Midair collisions happen from time to time. No, she feels much safer driving on the highway long distances on icy roads where she could potentially run into our friend Bill, from above.

Why bother going through all these examples? Because it helps explain why we have very little understanding of what risk is, and how we lack the ability for the most part to measure risk on any kind of an objective basis. This brings us back to equity options.

How many times have you heard someone tell you that selling naked options is risky? Or that calendar traders are almost risk free? Or how it’s much safer to be long gamma versus short gamma. Or how some friend of theirs has discovered this wonderful strategy that just can’t lose. They probably just got back from one of those seminars.

The problem we have here is in how we define risk. Let’s look at a few examples. Let’s take two people, Peggy and Bob. Peggy has just been taught a very low risk strategy, the calendar spread, or as commonly referred to as a long time spread or a horizontal spread. She learned this strategy at a seminar called, “How To Trade Calendar Spreads With Very Little Risk”. Peggy was taught that this trade had very little risk and it was very safe. Peggy has 100k in her brokerage account.

Bob is more of a gunslinger. Bob also has 100k in his account but he likes to sell naked straddles. Let’s say Peggy finds a wonderful calendar spread she wants to put on, and she can buy the spread for a dollar or in other words, a point. Let’s say Peggy decides to buy this spread 500 times. Her total cost is 50k on her 100k account. Now the good news is, Peggy can only lose the debit on this trade which is just one point. The bad news is, that’s $50,000!!!!!

Now Bob is going to sell a straddle on the QQQQ’s. But Bob is only going to sell it one time for a credit of 2 pts, or two hundred dollars. Now in theory, Bob is the more risky trader being that he is selling naked straddles and Peggy is the more conservative trader. But who is really taking more risk here. If Peggy is wrong and her time spread does not work out, she stands to lose $50,000 or half her entire account! How much money could Bob lose? Well in theory, the QQQQ’s could go to zero on the downside or as high as infinity to the upside, whatever level that is. But assuming Armageddon is not going to happen this month and assuming that this market cannot mathematically reach infinity as it is a never-ending number, how much could he really lose?

Let’s say the QQQQ’s are trading at 40 and let’s say we have the largest drop in the market’s history in a one month period, say 50%? That would equate to a 20 pt move in the QQQQ’s. How much would Bob stand to lose on this trade? Well, if he sold the 40 straddle one time for 2 pts, he would lose a total of $1,800 or 1.8% of his account. Not bad for Armageddon eh? What about Peggy? Peggy could lose $50,000 or 50% of her entire account on one trade. So the question now becomes, who is really taking more risk here, Peggy or Bob.

Well, I’m sure it’s obvious to most here that Peggy has taken substantially more risk then Bob, even though she has a textbook safer strategy. This leads us to question again how we define risk. Do we define it by strategy, or by dollar exposure? I hope it’s obvious to everyone here that risk must be looked at from the big picture. Saying you have a safe strategy means nothing. The infamous now defunct hedge fund, “Long Term Capital”, had a very safe arbitrage strategy that they employed. The problem was that they risked 100 times more money then they actually had so that just a 1% move, yes a full one percent move would wipe them completely out, and the entire US banking system with it. They had the same problem that Peggy currently has, that is a terrible misunderstanding of risk. And a terribly subjective definition of what they call a safe strategy.

In the end, it was Bob that was taking the least amount of risk selling his naked straddle on the QQQQ index. You see Bob knew very well that the key to risk management was not in the strategy, but rather the capital employed in the strategy. Peggy meanwhile has contacted her attorney to go after the person that told her how safe calendar spreads were. Maybe when this guy said safe, he meant she could only lose 100% of her capital on the trade. Clearly the word safe can be a very ambiguous term.

So in the end, Peggy has filed a lawsuit against the folks at, “How To Trade Calendar Spreads With Very Little Risk”. Of course her instructor from that seminar was injured in a terrible accident on an icy highway in Illinois involving our friend Susan who was afraid to fly, and some drunk on the road who turned out to be Bill. But Bill has other problems. The house he told Tom to buy in Evanston as an investment, rather then put it in the stock market, has taken a 20% hit due to an unexpectedly large increase in interest rates. Needless to say Tom is angry. Especially seeing how the stock market had yet another up year. And our friend Bob the gunslinger, well, the market really didn’t crash 50%. The QQQQ’s traded up a full point to 41 over the month. Bob made a $100 on the trade. I think he just made an offer for Tom’s home in Evanston seeing how the home took a 20% hit over the last year. Good work Bob! I hear Bob also attends the Chicago Options Traders Group. And his little daughter Virginia is the only student in her school who truly understands risk.

John

Google Message Board Up

I have set up a message board on Google's beta site. This message board will be for posting trade ideas and getting feedback from other members on trades you are proposing. This blogger will be used for posting articles and commentary as well as meeting reminders. Feel free to continue to post comments about the commentary or articles. There is a link at the bottom of this blogger that will allow you to subscribe to the message board.

Intuitively Understanding the Way Options are Priced

The Nobel Prize in Economics was awarded to Robert Merton, Fischer Black and Myron Scholes for their pioneering work in establishing the foundation for the financial engineering that has revolutionized contemporary finance. They developed an intellectually elegant model that enables traders to take a set of observable prices and to calculate mathematically a price for an option. While some may criticize it for the assumptions that it makes, the model has been instrumental in allowing traders to understand intuitively the behavioral characteristics of the product and it has facilitated the exponential growth of derivatives worldwide. Indeed, one could argue that because of its assumptions the model has forced traders to understand every aspect of options pricing. This article will explain intuitively the way in which the options pricing model was derived and it will illustrate the assumptions implicit in the model.


Let's take a look at an investor who wants to buy IBM stock. The buyer of an IBM call option has the right but not the obligation to buy IBM stock at the maturity date at a pre-set strike price. He will exercise this option if the option is in-the-money. That is to say, the buyer will exercise his right to purchase IBM stock if the strike price is less than the prevailing cash price for IBM stock at the time the option expires. The question the modeler has to answer is this. How do we evaluate what the stock price is going to be at maturity, an event that could take place months from now? The first assumption has to do with the way in which we model the process that characterizes the movement of the underlying price of IBM. We know that the price of IBM stock fluctuates. Perhaps it follows a trend. We have observed the volatility of the stock price. If we have a way of describing the statistical process underlying the IBM price, then we have taken the first critical step towards pricing the option.

Let us assume that the stock price follows a Markov process. This is simply a process in which only the current value of a variable is useful in forecasting what the future value of the variable could be.

ASSUMPTION 1: THE UNDERLYING PRICE IS LOGNORMALLY DISTRIBUTED. In fact, let us assume that the logarithm of the price is normally distributed such that it has a trend and a volatility that we can specify. Doing this enables us to predict what the expected value of the stock price will be and it also makes the model mathematically tractable. Using the normal distribution makes it easier to find a closed-form solution to the problem. A closed-form solution is simply an equation that we can use to determine the price of the option. Note that this means that volatility for the underlying price is constant and the same for all maturities. As we shall see in subsequent articles, there is usually a term structure to volatility in which different maturities have different volatilities. Remember that an option is not an option on the spot price but an option on the forward price. Different maturities will trade with different volatility, in practice, because of cash flow events, expectations of political instability, political events, management changes, etc.

ASSUMPTION 2: THE SHORT SELLING OF SECURITIES WITH THE FULL USE OF PROCEEDS IS PERMITTED.When we talked about delta hedging in "Derivatives Explained," we assumed that we could buy and sell stock against our options position in order to capture the effects of a volatile underlying price, thereby paying for the option premium over the life of the instrument. In order to sell stock, there can be no restriction on short sales.

ASSUMPTION 3: THERE ARE NO TRANSACTION COSTS OR TAXES. ALL SECURITIES ARE PERFECTLY DESIRABLE. Transaction costs, such as brokerage, and taxes would distort the simple problem of trying to understand how to price an option. In practice, the investor or the options professional accounts for these factors in the course of doing business. Transaction costs and taxes will distort the delta hedging decision, providing a disincentive for delta hedging and altering the way in which we determine the option's value.

ASSUMPTION 4: THERE ARE NO DIVIDENDS DURING THE LIFE OF THE DERIVATIVE SECURITY. Again, we ignore dividends in the derivation of the Black-Scholes model because of the distortionary effects these can have on our delta hedging decision. If we buy a call option and need to delta hedge it by short selling securities, we may be hesitant to short sell securities that pay a dividend.

ASSUMPTION 5: THERE ARE NO RISKLESS ARBITRAGE OPPORTUNITIES. This is an assumption of efficient markets theory. An arbitrage opportunity exists when one can buy and sell the same instrument (or virtually the same instrument) simultaneously for different prices, thereby locking in a price. Because the transaction is instantaneous, there is no risk to the individual. A market may be said to be efficient if there are no such opportunities. Put another way, as soon as such opportunities arise, they are immediately realized by some astute investor. You would not expect them to last for long, as markets will correct themselves rationally. Or, so says the theory. Ironically, Long Term Capital Management claimed to be engaging in arbitrage by buying and selling similar (but not identical) instruments with holding periods in excess of a few weeks. This is ironic because some of the leaders in financial research were part of this firm. It turned out that the similarity between those instruments was not as solid or as durable as the rocket scientists originally thought.


ASSUMPTION 6: SECURITY TRADING IS CONTINUOUS. Prices of stocks on North American exchanges move in discrete increments, such as 1/32. By assuming that prices can trade in a mathematically continuous fashion, the model is more mathematically tractable. For example, if IBM's stock traded at 189.8975, there would be no reason why the next price could not be infinitesimally higher, say 189.8975001.

ASSUMPTION 7: THE RISK-FREE RATE OF INTEREST, r, IS CONSTANT AND THE SAME FOR ALL MATURITIES. This is a big assumption. It states that the government yield curve is flat. We know that is not true, just from common sense. But, in order to solve the model for a wasting asset, it is important to model rates as constant.

INTUITION Having made all of these assumptions, how did Black, Scholes and Merton apply them to the pricing of options? They modeled a portfolio that consisted of one unit of the option and a fraction (the delta) of shares in the underlying instrument of the option, choosing the delta so that the portfolio did not change in value for small movements in the price of the underlying price. By doing so, they mathematically removed the uncertain element of the Wiener process. There was no longer any risk in the portfolio. Therefore, they reasoned, the test portfolio must have the same return as a riskless portfolio, r.

Solving this differential equation using boundary conditions fixed by whether or not the derivative was a call or a put resulted in the closed-form solution for the options price. Now, when you want to price an option, you input the following parameters into your Black-Scholes calculator and you have the price:

Stock's current price
Strike price
Today's date
Maturity Date
Delivery Date
Risk-free interest rate
Stock price implied volatility
Call or a Put

Note that one of the items here is "implied volatility." Let's say you're the IBM investor and you observe everything in the market, including the price of the call option you want to buy, except for the volatility. You can use the Black-Scholes calculator to "back-out" the volatility that the market is using. Doing so gives you the so-called "implied volatility." Subsequent articles will discuss the ways in which options pricing has evolved, in addressing the shortcomings of the Black-Scholes assumptions and in extending the Black-Scholes approach to other markets, including currencies, dividend-paying equities, futures, etc.

Article courtesy of Chand Sooran

Overview of the Greeks

When we purchase an option, we can trade the cash instrument (called "trading spot" or "trading the cash"), hoping to realize more profit from trading the cash than we pay initially in premium for the option. When we sell an option, we hope that the premium that we are paid upfront dwarfs the losses we will sustain from trading the cash.

When we buy options, we are said to be buying volatility. We make money if the spot rate is volatile enough for us to pay for the option. When we sell options, we are selling volatility. We make money if spot is calm enough that we don't have to hedge the exposure frequently.

However, delta hedging is not the only way for us to make money with options. The genius of derivatives is that it allows us to take positions in (or to hedge against fluctuations in) other aspects of the cash instrument's price evolution. Derivatives are dangerous if we do not understand or address each potential dimension of their risk.

Here are several examples. With a simple plain vanilla option, we can make money if implied volatility moves in our favor. With currency futures, currency forwards and currency options, we can speculate on the spread between interest rates in two different countries for a maturity date. With some exotic options, we can buy an option that appreciates in value with the passage of time (all other things being constant) and that also appreciates in value with movement lower in implied volatility.

Options dealers and savvy options traders use time-proven techniques to break down the risks in an options position or in a portfolio of options, futures, forwards and cash positions into information that is more readily comprehensible and therefore more easily positioned or hedged. This method of analysis employs tools called the "greeks", as well as using simulation, scenario analysis and value-at-risk analysis.

The greeks get their name from the fact that the sensitivities of an option to various market parametres are labelled with letters from the greek alphabet.

DELTA

The delta of an option is the sensitivity of the option's price to very small changes in the price of the underlying instrument. When we talked about trading spot around the options position in order to realize profit that would pay for the option's premium, we were talking about trading the delta.

By taking an opposite position equal in size to the option's delta, we immunize the option against profit and loss variability due to small changes in the spot rate.

For example, consider our equity call option with a strike price of $50 when the underlying price is $50. Because it is an at-the-money option, we know that the delta is 50. The delta is expressed in terms of a percentage of the notional amount. An option that is hopelessly out-of-the-money very near to expiration has a delta of 0. Also, near expiration, an option that is completely in-the-money with no danger of being thrown out-of-the-money has a delta of 100. Everything else is in between. At-the-money options have a delta of 50.

Our equity call has a positive delta because it is a long position in a call. If we exercise the call, we will end up being long the stock.An equity put struck at-the-money would have a negative delta of 50. If we exercise the put, we will end up being short the stock.Similarly, shorting a call implies a negative delta and shorting a put implies a positive delta.

To delta hedge our long at-the-money equity call struck at $50, we need to know the notional amount. Let it be $100 for the sake of argument. Therefore, the delta position implied by our option is $50 (i.e. 50/100 x $100).

If we take a short position in the cash market (assuming that shorting the stock is feasible and liquid enough) at the spot price of $50, we have immunized the option's sensitivity to small changes in the spot price.If spot goes to $48, the $2 we make on the short stock position will offset the $2 we will lose on the change in price of the option. Similarly, if spot goes to $52, the $2 we make on the option premium will be offset by the $2 we will lose on the short stock position.

Assuming that we own the option, if we plot the curve of the option premium (on the y-axis) against the price of the underlying instrument (on the x-axis), everything else remaining constant, we obtain a convex curve. The slope of this convex curve is the option's delta.

GAMMA

Things begin to get interesting for larger moves in the stock price.
If spot goes to $70, we might expect to make $1150 on the option price while only losing $1000 on the short stock position.

How does this work? Because of the convexity of the option's curve, the delta will change if spot moves enough.If spot goes to $52, the delta might change to 52. If spot goes to $55, the delta might change to 57. If spot goes to $60, the delta might change to 64. If spot goes to $70, the delta might be 80. The option position behaves as if it is a miraculous trade that seemingly gets longer as spot goes higher in a non-linear fashion.

Since we have only hedged our exposure to a position that is long $50 at $50, the hedged option position will continue to make money on the incremental position, i.e. the part that appeared to get longer from $50 to $70 at an average rate of say $65.
The greater the convexity of the option curve, the more bang for our long option buck and the more pain we will endure if we are short the option, in a volatile environment.

Convexity is described by the greek letter called "gamma". Mathematically, gamma is the second derivative of the option's price with respect to the underlying cash price. Intuitively, it is the sensitivity of the delta (or rate of change of the delta) with respect to the cash price.

VEGA

We know that options will be expensive when volatility is actually high or when volatility is thought to be heading higher. We also know that options are cheap when volatility is low or when volatility is believed to be heading lower.
There are two kinds of volatility between which we must distinguish: actual volatility and implied volatility.

Actual volatility is a measure of how much the spot price moves around, in fact, for a given time period. Implied volatility is the volatility used in the calculation of the option's price. Without going into the mathematics of it at this point, suffice it to say that we can back out (or "imply") the volatility used to calculate an option's price, if we know with certainty the value of each of the other variables used in the option valuation formula. For the Black-Scholes-Merton model, the list of these remaining variables typically includes the underlying cash price, the maturity date, the delivery date, the strike price and the risk-free rate of interest.

Some of the more developed derivatives markets, such as the foreign exchange options market, actually trade in terms of implied volatility or "vol" instead of specifying a price at which may buy or sell the option in question.

The sensitivity of an option's price to changes in its implied volatility, all other things being constant, is called the "vega". Let us consider the case where we have just bought and delta hedged the long $50 equity call in the stock of company ABC Inc. Spot does not move for a couple of hours until a headline tells the market that DEF Inc. has made a hostile bid for ABC Inc.

Even though spot does not move immediately because traders are confused about the implications of the DEF bid, implied volatilities jump much higher because of the additional uncertainty for ABC's future prospects posed by the DEF initiative.

We will make money, not from delta hedging, but from the jump up in the value of the option. We now own something that has become more valuable in the blink of an eye because the market believes that the volatility of the ABC stock price will be greater than previously thought. Pity the poor short option holder.

This article was courtesy of Chand Sooran.

Recommended Reading List

These are in my opinion must read books in order to build a solid foundation in your options trading. They are listed in the order in which they should be read. Most of these books can be purchased used at Amazon. The Cottle book is actually an online PDF file that can be downloaded for free. You can e-mail me for the link.

"Options as a Strategic Investment" by Lawrence G. McMillan

"Fundamentals of the Options Market" by Mike Williams and Amy Hoffman

"Options Workbook" by Anthony J. Saliba

"Option Volatility and Pricing" by Sheldon Natenburg

"Options Market Making" by Jan Allen Baird

"Coulda Woulda Shoulda" by Charles Cottle

Everyone Is Getting Rich Trading Options!

If you ever stay up late at night, or watch TV early on the weekends, you'll often see infomercials on how to get rich trading. Many of these involve options. Two that come to mind are Optionetics and Options Made Easy.

You'll often see free seminars packed with people curious how they too can work two hours a week and make millions on the side. They throw in the proverbial retired sixty five year old woman who just learned what an option was weeks ago and now trades them one hour a day. She is giving her testimonial of course in front of her new ocean front home in Florida with two nice German cars in the driveway. And what is that in the background? Oh, that's her new yacht.

You see this woman, we'll call her Margaret, just learned at a seminar that you can actually make money when the market goes up and down. Apparently this little nugget of information alone nets her 5k a day. OK, time for a quick pan over back to the packed full seminar. Often you'll see an attractive young woman who appears to be reporting live from the seminar floor as if she is giving everyone an injury update during a Monday night football game.

Amazingly, everyone she interviews is just overwhelmed with excitement with what they have just learned. And I mean everyone. There is not one skeptical person in the house. You would think these people are being re-united with lost loved ones they haven't seen in years. Nope. They just learned that when you buy a straddle, you don't care where the stock goes, up or down. Everyone makes money.

Don't tell these people the economy is slowing down. In fact, these seminars alone might be the reason we have seen such an increase in real estate prices all over the country from California to Florida. I always wonder if I'm not seeing the exact same people on all these infomercials. Some of them look familiar from the "buying real estate with no money down", and "how to make millions buying and selling on Ebay" infomercials.

So what gives? Is this really an elaborate hoax played on the unsuspecting public? Are these people paid actors giving a performance that would make even Robert Deniro proud? Or perhaps there is some truth to what we are seeing but there is some slight of hand being performed. You know, the way Michael Moore can make a documentary based on facts with no facts actually being presented.

One thing is for sure. People are making money trading options. I don't know if the people at these seminars are, but they sure seem happy. And that's what it's all about right, being happy? If money is just a means to becoming happy, well then I guess these people are already there. They have reached their goal. Whether or not they have made a dime trading options or they are just happy to get out of the house and be in a room with 500 other people searching for the same answers, is really irrelevant. They have found their holy grail. That is starring in a television infomercial. Now we return you to your regularly scheduled infomercial already in progress.

Welcome

I just wanted to take this time to welcome everyone to the Chicago Options Traders blog. I will be posting on here from time to time as well as answering questions from the group and also just allowing the group to interact with each other. I will also be posting relevant articles that I find of interest to the group.

In order to post to the boards you need to register. Very simple and painfree process. I started this blog at the recommendation of one of our members. I felt sending out mass e-mails to everyone was getting burdensome with every question and answer. This will work much better.

Good trading to everyone!