Monday, March 23, 2015

Volatility: Defining high

Update 3/28/2015: This essay contains two paper trades, in AAL and TSLA, both built from options expiring March 28.

The paper AAL position expired out of the money for maximum profit. The stock price declined by -3.9% over the five-day lifespan of the position, or a -281% annual rate. The paper options produced  a 100% yield on debity, for a 7,300% annual rate.

The paper TSLA position expired in the money and was assigned for a loss. The stock price declined by -7.0% over the five-day lifespan of the position, or a -509% annual rate. The options positions produced a 100% yield on a debit, for a 7,300% annual rate. However, the options were assigned, on paper dumping short shares of TSLA into my account. The market price was -2.6% below the options contract strike price, producing an instant loss of that amount.

My trading of options spreads has in part been based on the work of Sheldon Natenberg, whose book, Options Volatility & Pricing, was used as a text in an advanced class I attended in Chicago taught by Tom Sosnoff, the founder of the ThinkOrSwim brokerage. (These days Sosnoff is most visible through his TastyTrade video blog.)

It's a thoughtful book that dives deep into the theory of option behavior, and Sosnoff's lectures brought the theory aggressively into the realm of practice. It was by far the best session on options I've ever been involved in.

Natenberg's book includes a chart on picking the right strategy that relies heavily on implied volatility. If volatility is high, trade this way, if low, trade that way, and if moderate, do something else.

As applied to vertical option spreads (and combos of them, such as iron condors), Natenberg's advice is to trade short spreads, sold for a credit, if volatility is high, long spreads, bought with a debit, if volatility is low, and trade the trade if volatility is moderate.

But what is "high"? Or "low"? O "moderate"? No one could say, leaving it up to the trader to cobble together a definition.

At this point, readers unfamiliar with implied volatility and options spreads may want to go off an do some reading on their own. In addition to implied volatility, the key terms are "vertical spread", "long", "short" and the names of specific structures: "bull put spread", "bear call spread" and "iron condor".

In my trading, I've measured volatility by where it stands in relation to its own history. If volatility in AAPL at the high end of its travels for the past month, or six months, or year, then I define volatility as high.

Eventually I made the definition more rigorous: Calculate the present implied volatilities percentile within the range of the most recent rise. If it is in the 60th percentile or higher, then volatility is high, and in the 40th percentile or lower, then it is low. That's the method I'm using now.

One outcome of that approach is that volatility tends to range in the upper percentiles as earnings announcements approach, and then collapse into the lower percentiles after the announcement. This is a characteristic I rely on for trading under my volatility rules,

Another approach would be to compare a symbol's volatility with that of another symbol. For example, there is the VIX, which tracks the implied volatility of the stocks in the S&P 500. By this measure, I would define high and low as a multiple of the VIX, which, in a moment of whimsy, I've decided to term "Vixen".

Definition: Vixen - Implied volatility divided by the VIX

For example, AAPL's implied volatility is presently 25.57%. The VIX stands at 13.33%. How many Vixen does AAPL's volatility represent?

Calculation: APPL Volatility / VIX = ? Vixens, 25.57 / 13.33 = 1.9 Vixens

APPL's volatility, then, stands nearly double that of the S&P 500, which seems relatively high.

I did the calculation on 129 large cap symbols that otherwise met my criteria for volume (greater than three million shares per day) and price ($20 or greater), rounding their Vixens to the nearest whole number.

Of the symbols, 16 had volatility that rounded to 3 Vixens, a high level indeed, and 86, including AAPL, had volatility that rounded to 2 Vixens.

But is absolute volatility defined in relation to an external measure truly a valid way to look at it? True, some analysts measure their performance in comparison to the S&P 500 or some other index. But when it comes to the price of a stock, we say it's high or low compared to its past history.

To say that AAPL is "high: at $127.23 per share compared to MSFT at $42.42 per share is to completely miss the point. To say that AAPL is trading 4.7% below its November 2014 peak while MSFT is trading 14.4% below its November peak is a perfectly valid comparison of relative performance: AAPL is doing three times better than MSFT is.

For trading short options spreads, however, volatility performs a function. It defines how much of a range is covered by the zone of profitability. If the price is outside of that zone, the trade is a loser. Within the zone, it makes money.

In that respect, high absolute volatility can help me earn a profit, even if it is far below where it was a month ago.

Another function of volatility is that when it is high, it widens the bid/ask spread. But this is also a function of its absolute value, not where it stands in comparison with the past. A 40% volatility will result in a wider bid/ask spread, meaning that the short options I sell will go for more in comparison with the long options I buy.

Where volatility in comparison with its own history becomes important is when it declines. If I open a short vertical spread with a wide bid/ask spread, then if the volatility declines I'm able to close the position with a narrower bid/ask spread. That lowers my cost in buying back the short options while somewhat raising the cost of buying back the long options. For short spreads, it's a net gain for me.

True though that statement is, it looses sight of the goal of trading a short vertical spread. These positions, done the way I do them, are very short lived -- generally from 10 days down to two days. My goal is to have each position expire out-of-the-money and therefore totally worthless, which gives me the maximum possible profit.

If the position goes down to zero, then there is no unravelling. I keep the premium and the position disappears like the morning fog. Under those circumstances, the collapse in volatility is simply irrelevant.

To try out these musings, I'm going to do some paper trades. I'll be looking for highly liquid symbols with implied volatility at multiples of the VIX, the higher the better.

I've found myself more interested in the iron condor structure, which is profitable within a range but unprofitable outside of that range. It pays higher premiums and provides more favorable risk/reward ratios compared to the directional structures, such as simple vertical spreads. 

So I'll focus on non-trending stocks, using the 55-day price channel as a frame to help me identify them.

My first two analyses follow: The airline AAL and the electric car maker TSLA. These are paper trades for the purpose of study. I'm not risking any money on these virtual positions.

Both symbols have Weeklys among their options inventories, and I shall paper-trade the MAR4 series of options, which trades for the last time on March 27, four days hence.

AAL - paper trade

The goal of my paper trade is to construct a direction-neutral position with a zone of profitability at expiration covering all of the one standard deviation range implied by volatility and options pricing, or the 30-day hourly chart support and resistance range, whichever is wider.


Click on chart to enlarge.
AAL 180 days 4-hour bars
Implied volatility stands at 36.16%, or 2.8 Vixen, multiples of the VIX, which measures volatility on the S&P 500. Volatility is below the starting point of its most recent rise.

The chart range runs below the two standard deviation range to the downside, reflecting an extended rise, including a gap, up to the high point, from which is the price has retreated somewhat.

Ranges implied by options and the chart
WeekSD1 68.2%SD2 95%Chart
Upper 57.0559.1356.05
Implied volatility 1 and 2 standard deviations; chart support and resistance

The Trade

Because the width of the chart range makes it impossible to construct a paper trade with a good premium, I'll focus on the one standard deviation range, doing a bit of trimming at the margins. I'm aiming for a better probability at the upside, since the price is near the top of the range.

Iron condor short the $57 calls and long the $58 calls,
short the $54 puts and long the $53 puts
sold for a credit and expiring March 28
Probability of expiring out-of-the-money


The risk/reward ratio stands at 2:1. The paper premium is 32 cents with the stock at $54.77.

TSLA - paper trade


Click on chart to enlarge.
TSLA 30 days hourly bars
Implied volatility stands at 41.12%, or 3.1 Vixens. Volatility stands in the 16th percentile of its most recent rise.

Ranges implied by options and the chart
WeekSD1 68.2%SD2 95%Chart
Implied volatility 1 and 2 standard deviations; chart support and resistance

The Trade

I've used the upper boundary of the chart range and the lower boundary of the one standard deviation range in order to get a reasonable risk/reward ratio. Covering all of either raised the stakes beyond my comfort zone.

Iron condor short the $205 calls and long the $207.50 calls,
short the $190 puts and long the $187.50 puts
sold for a credit and expiring March 28
Probability of expiring out-of-the-money


The risk/reward ratio stands at 2:1.  The paper premium is 72 cents with the stock at $198.86.

Decision for My Account

These are paper trades. No money is involved. I'll post results upon expiraton.

-- Tim Bovee, Portland, Oregon, March 23, 2015


My volatility trading rules can be read here. For a discussion of the rationale behind the rules, see my essay, "Rules for very short term trades".

The directional score is calculated as the sum of the following:
  • Zacks rating --The Zacks ratings are translated as follows: 1=2, 2=1, 3=0, 4=-1 and 5=-2.
  • Enthusiasm rating --: A single percentage derived from the number of analysts whose opinions are in one of five categories: Strong buy, buy, hold, sell and strong sell.
  • Strong buy share -- The percentage of all analysts who rank the stock strong buy. If the share is 60% or greater, the score is 1; if 40% or less, then the score is -1; otherwise, the score is zero.
  • Ethusiasm momentum -- The score is 1 if today’s enthusiasm rating is larger than the rating 30 days earlier; otherwise, the score is zero.
  • 30-day direction -- The trend that best describes the 30-day chart: 1 for an uptrend, -1 for a downtrend and zero for a sideways trend.
  • One-day direction -- The trend that best describes the one-day chart: 1 for an uptrend, -1 for a downtrend and zero for a sideways trend.

From time to time I use the number 68.2% in using applied volatility to calculate the expected trading range. This comes from statistics and refers to the one standard deviation boundaries, which are expected to contain 68.2% of whatever is being studied. Putting it another way, given an item (a trade or whatever), there is a 68.2% chance that it will appear within those boundaries.

Elliott wave analysis tracks patterns in price movements. The principal practitioner of Elliott wave analysis is Robert Prechter at Elliott Wave International. His book, Elliott Wave Principle, is a must-read for people interested in this form of analysis, as is his most recent publication, Visual Guide to Elliott Wave Trading

Several web sites summarize Elliott wave theory, among them, Investopedia, StockCharts and Wikipedia.


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Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.

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