Volatility - Part I

One of the most important aspects of the trading process is understanding and using Volatility.  There are two types of Volatility that we will explore over the next few posts: Historical Volatility (HV) and Implied Volatility (IV).

Historical Volatility (HV) is the realized volatility of a financial instrument over a given time period.  Generally, this measure is calculated by determining the average deviation from the average price of a financial instrument in the given time period.  Standard deviation is the most common but not the only way to calculate historical volatility.  Also known as "statistical volatility,"  this measure is frequently compared with implied volatility to determine if options prices are over- or undervalued.

Now, with the legal definition out of the way, let's take a look at a simplified view of HV.  HV is simply how much the underlying (Stock) changes in price.  It is usually calculated by taking the daily closing prices and averaging how much change is occurring over a given period of time. 

The Option Chain within MachTrader has the HV and IV information at the top (as shown by the red box).  For the HV, this gives the Historical Volatility within that specific time frame.


Implied Volatility (IV) is the estimated volatility of a security's price.  In general, implied volatility increases when the market is bearish and decreases when the market is bullish.  This is due to the common belief that bearish markets are more risky than bullish markets.


In addition to known factors such as market price, interest rate, expiration date, and strike price, implied volatility is used in calculating an option's premium.  IV can be derived from a model such as the Black-Scholes Model.


Now - the simplified version:  Implied Volatility of an option represents what traders expect to happen in the future of the stock and how volatile they expect it to become.  In other words, it is the volatility of the future.  The IV is the surrogate projection of an Option's price. 

Next post we will explore how to use the HV and IV to determine if the Volatility is in a "sweet spot" to trade Calls, Puts or Covered Calls.

 

Risk Graphs

The Risk Graph may be one of the most under-utilized tools available to the active trader.  Available in MachTrader, the risk graph, when understood, is a powerful compliment to the traders toolkit.

The Risk Graph solicits stock information as well as option information and then builds the corresponding risk graph.  The example risk graph shown is for a Bull Put Spread.  As the risk graph is produced, current stock price information is given within the black box and updates "real time" throughout the trading day.  The trader can watch the price of the stock move and the impact upon his/her position.

The blue dotted horizontal line in the middle of the risk graph is the 0.00 (zero) line. If the risk graph is above the zero line, then the position will yield a net profit, if it is below, then the net will be negative.  The black line is the risk graph of the position at expiration.

When the stock is in such a position that the stock price vertical line intersects the risk graph, then the corresponding net profit or loss is shown at the right.  The risk graph uses the black scholes formula to determine the net profit or loss.


The blue line comes on as a default whenever a risk graph is created.  The blue line (selected in the lower left) is the risk graph of the position now (in other words - today).  Notice that the number of calendar days that remain prior to expiration is listed.  The default colors of red, green and magenta and corresponding entry boxes are available to enter up to four different risk graph lines with four different time frames prior to expiration.

 If the trader wants to compare the current chart with the risk graph, he/she presses the "Show Chart" button on the lower right.  This is especially helpful to determine support and/or resistance levels as part of the criteria for spread trades.

As an options trader, the risk graph is a very valuable tool in assessing the current state of the options position and the stock.

Intermediate Trading Lab

Notes for the March 10, 2010 Intermediate Trading Lab are now posted on the Trading Lab Page.

LEAPS Covered Write - Part II

In the last post we explored setting up the LEAPS Covered Write.  Proper management of this trade is essential.  As you can see by the Risk Graph, a flat or moderately bullish underlying is the best choice.  The Risk Graph is depicted below which shows a position staged today on the SPY.

Our risk is limited and our reward is also limited.  The basic rules, as a reminder, are that we choose the LEAPS as the underlying instead of Stock.  This drastically reduces the amount of capital up front.  When we choose the LEAPS, we make sure that it has a high Delta.  The trader will normally pick a 0.90 or better Delta.  In terms of time to sell the short-term Call, it is wise to select the front month (the first available month) and choose the Strike Price that is the first OTM based on the Stock price.

A must have part of any trade is the proper Trading Plan.  The phrase “Plan Your Trade and Trade Your Plan” is very appropriate.  If the trader has specific goals in mind in terms of risk, he/she should size the trade to their maximum allowable loss.  For example: if the trader decides that he/she can only afford to lose $500.00 per trade, then the trade must be sized so that the maximum risk for that trade is only $500.00.  Proper discipline will lead to building of a trading account.  Too many traders try to hit a home run every time they trade.  Because their mind set is completely un-realistic, they become frustrated and eventually give up.  I believe in being disciplined and I’ll take a base hit any time.

After entering the LEAPS Covered Write, the trader then monitors the underlying Stock.  If the Stock stays flat, then the position should be left alone and the short Option will expire.  The Maximum Reward is realized.  The LEAPS Call is retained and the trader can then make a determination if the position meets the requirements to do again. 

If the Stock goes up, then, just prior to expiration, the trader will exit the entire position.  Why?  If the Stock goes above the short-term Strike Price, then assignment WILL happen AT EXPIRATION if not sooner.  A question was asked about the risks associated with assignment - and the risk is that we will have to sell the Stock.  The issue with this is that the trader will not own the Stock at this point.  So, if we are assigned we need to purchase the Stock in order to sell it.  If this happens prior to expiration, then the LEAPS Call can be exercised, the stock can be purchased and then the assignment is fulfilled.  While this can still return a small profit, it normally isn’t as great as “unwrapping” out of the entire trade prior to expiration.  The reason that we purchased the LEAPS Call with a high Delta was for this very reason.  Remember that the high Delta builds the LEAPS Call value and so if the Stock goes up we consider unwrapping about a day or two prior to expiration.  We will Buy to Close the short-term Call and we will Sell to Close the LEAPS Call.  In many instances this can return almost as much, percentage wise, as the Maximum Reward.  Normally, we DO NOT want to ride the trade through expiration if the Stock is above the Strike Price.

If the Stock drops in value, then at a pre-determined point on the stock, use a contingency order and unwrap out of the position.  Again, Buy to Close the short-term Call Options and Sell to Close the LEAPS Calls.

For traders that want to avoid the capital intensity of a regular Covered Call and are willing to spend a little more time in maintaining this trade, the LEAPS Covered Write may be the answer.

LEAPS Covered Write - Part I

I've been known to take a few leaps in my day (and I've been told to take a few as well), but one that I really like to take is the LEAPS Covered Write.  This Option Strategy is one that embraces the warm fuzzy feeling of a Covered Call, yet allows the trader to leverage and still retain some safety in the trade.  This is a Calendar or Diagonal Spread Trade that enables the trader to have monthly income while lowering the amount of capital required upfront.

With some Covered Call traders, the number one problem they face is being able to buy enough Stock to make the trade worthwhile.  With the LCW the underlying is the LEAPS and the cost is a fraction of what the trader would normally have to pay for the Stock.

The LEAPS Covered Write is assembled by purchasing a LEAPS that is deep in-the-money (ITM) and that has a high Delta (preferably .90 or better) and then selling the short-term Call Option which is out-of-the-money (OTM). 

Let's take a look at one of the most widely traded products in the market - an ETF named the SPY.

 

The LCW requires that you have a flat or moderately bullish underlying.  The SPY is trading at $110.82.  For many a Covered Call trade would be too expensive and the return on the trade is minimal (about 1.5%).   Instead of having to buy the SPY, we look to the LEAPS to be the substitute.  In checking for the proper LEAPS the trader normally selects the first expiration month available and a deep in-the-money strike.  The Dec 90 LEAPS are chosen.  For Index or ETF underlying products, the LEAPS may or may not be in January.  In this case the 90 LEAPS Calls have a 0.9027 Delta and a cost of $22.36.  The LEAPS are purchased and then the short-term Call (the March $111.00) is sold (the same Call Option if the trader was doing a regular Covered Call).  Instead of a 1.5% return, the structure of this trade returns 7.7%  ($1.74 / $22.36).  By structuring this trade, we've essentially increased our return by about 7x!

Next post, we will explore managing this trade and a proper exit strategy.