The Trader Development Stage Model and the Jump from Stocks to Options

First, thanks to all who commented or wrote to me about the trader development stage model, I was quite surprised and heartened by the response.

When I was in the process of assembling my initial draft of the trader stage development model, I had in mind a novice trader that was focusing primarily on stocks, but perhaps occasionally trading ETFs. With respect to options, my sense is that for the most part, novice traders avoid options entirely or take an occasional gamble on a potential big winner by buying out of the money calls or puts.

Looking at the model, however, it quickly dawned on me why so many traders have trouble making the transition from trading stocks to trading options. I asked myself two questions:

1. What is the motivation for a stock trader for jumping into trading options?
   
2. How far has the trader progressed in terms of the stage development model at the time he or she decides to trade options?

I suspect quite a few beginning traders get frustrated with some of the stage one issues associated with entries, leverage and position sizing and before coming to terms with these issues, they decide that stocks just aren’t the right trading vehicle for getting rich in a hurry. Attracted by the leverage potential of options, these traders make the jump from stocks to options and in so doing, simply magnify the cost of their mistakes. Of course, this is absolutely the worst way to approach options. Almost without exception, traders who follow this course of action succeed only in accelerating the time it takes to blow out their account.

The situation is only marginally better for traders who make the jump to options after advancing to stage two and are grappling with how to cut losses while letting winners run. With options positions much more volatile than stocks and spreads much wider, many of the exit strategies that work well for stocks do not work as well with options. Further, some traders become confused about whether to use the options, the underlying or both as their cues for when to exit. On a personal level, while I think mastering the art of exiting positions is a critical success factor for anyone who trades stocks, I found that porting the lessons I learned about stock exit strategies to options was nowhere near as easy as I had hoped.

Even for those traders who have reached stage three of the development model, options will be difficult to trade profitably, but these traders should understand most of the hurdles to success and what it takes to overcome them. Still, edges that work for stocks don’t necessarily work for options and risk management becomes much more complicated and difficult.

The bottom line is that for those stage three stock traders who are interested in augmenting their trading with options, their time and effort will likely be rewarded. On the other hand, for those traders who are still mired in stage one and stage two of their development process, options are almost certain to be a disaster and result in large losses.

If you are thinking about making the jump to options, make sure you undertake an honest self-assessment before diving in and be sure to make risk management your number one priority.

For some related posts, readers should check out:

• Draft Trader Development Stage Model
• The Risk Library

Draft Trader Development Stage Model

One of the under appreciated joys of blogging is the wide variety of people who you end up corresponding with across the globe – and whose paths would likely never have intersected my own had it not been for the blog.

Partly as a result of the blog, I have a better sense of what goes on in the heads of other traders, what issues they struggle with and how they do – or sometimes don't – overcome obstacles to success.

I have enough anecdotal evidence that suggests there is something of a typical development path that many retail traders follow as they grow and develop as traders. In an effort to start a dialogue about this and to give the blog a framework to refer back to in future posts, I thought I would post a draft of the mental model that is forming in my head.

Frankly, I am surprised I have not seen a similar graphic and if there is one out there, I would be interested to hear about it.

Keep in mind that as best I can, I have attempted to keep the model simple. Once the basics have been debated and reformed, then it is a lot easier to add in some of the complexity.

So…without further ado, I have appended below the first draft of the trader development stage model, which is hopefully relatively self-explanatory. Note that the vertical gray arrows are supposed to represent tension between related issues (leverage vs. position sizing, minimizing losers while maximizing winners, developing an edge vs. diversification.) Also, while I consider all the issues to be iterative, I suggest that the iteration process in the third stage is continuous.

As always, all feedback is appreciated.

Chart of the Week: VIX Macro Cycles and a New Floor in the VIX

The last time I updated my as VIX macro cycle chart, a little more than five months ago, the VIX had just dipped below 40.00 and I was looking at a bottom as low as 25.00 or so. For awhile, the area around 24.00 offered significant support, but with Wednesday’s low of 22.19, it is time to formally update my thinking about a new floor in the VIX and to place the current declining volatility environment in the context the two decades of VIX historical data.

This week's chart of the week below shows seven different VIX macro cycles, typically of 2-4 years in duration, dating back to the 1990 historical reconstructions of VIX data. The chart highlights just how extreme and unusual the VIX spikes and persistent high volatility was during the latter part of 2008 and the first few months of 2009. I find it interesting that this monthly chart shows three consecutive months of doji candlestick patterns with almost identical real bodies – meaning that despite the wide ranges during the month, for the last three months the opening and closing values of the VIX were very similar.

Note also that during the one previous instance of extended high volatility, from 1998 to 2003, strong support was found in the 20-22 range.

In fact, the lifetime average (mean) of the VIX since 1990 stands at 20.25, while the 10-year average is 22.11.

For these and other reasons, I expect that the 21.50-22.00 level will hold up as a VIX floor at least through the end of the calendar year.

Similarly, the most recent VIX macro cycle, which began in December 2008 and consisted of a period of declining volatility, may already have ended and is almost certain to be over by the end of the year.

For additional posts on VIX macro cycles, readers are encouraged to check out:

• The New VIX Macro Cycle Picture (4/23/09)
• Recent Volatility and VIX Macro Cycles (10/30/08)
• VIX Macro Cycle Update (3/19/08)
• Was 2007 the Beginning of a New Era in Volatility? (12/24/07)
• VIX Macro Cycles (9/10/07)

[source: StockCharts]

End of September Links

As always – and in an effort to ensure minimal overlap with some of the other excellent sources of links – I give preference to material that focuses on the VIX and volatility, options, market sentiment, and ETFs:

• The Origins of Behavioral Economics: Kahneman Interview (Steve Hsu, Information Processing)
• Which Contrarians are Correct About the Stock Market? (Dr. Duru, One-Twenty Two)
• Time to Close Long Positions (Francisco Lorca, Volatility Forecasting)
• 2CS Update (Tom Drake, Putting the Pieces Together…)
• Market Recap 09/24/09: CPCE Calls for a Top Again (Yong Pan, Cobra’s Market View)
• S&P Technicals Weakening (Kevin’s Market Blog)
• Viewing the Recent Breakdown in Oil and Rally in the Dollar (Corey Rosenbloom, Afraid to Trade)
• Can You Beat the Market? Part V. Collars Outperform Buy and Hold (Mark Wolfinger, Options for Rookies)
• Initial Conclusions/Theories Regarding Run Frequency (David Varadi, CSS Analytics)
• Hedging, Under the Academic Microscope (Steven Sears, Barron’s)
• Lessons Learned from a VIX Put Matrix (Tyler Craig, Know Your Options)
• Shorty Fire in AIG (Adam Warner, Daily Options Report)
• Bloomberg Options Blooper (Wayne, Sigma Options)
• Volatility Skew in Crude Oil Options (Don Fishback’s Market Update
• Perot Systems – Options Order Flow Leads the Way Again (Ron, Livevol)
• Reacting to News: The RIMM Lesson (Jeff Miller, A Dash of Insight)
• Economy Improves, But Concerns Remain (James Hamilton, Econbrowser)
• When Will the Economy Start to Add Jobs? (V.) Putting the Indicators Together (Hale Stewart, The Bonddad Blog)
• Food Stamps at Record (Sudden Debt)
• Household Financial Burdens Ease (Scott Grannis, Calafia Beach Pundit)
• “Buy the Dip” Mentality Fully Entrenched (Michael Shedlock, Mish’s Global Economic Trend Analysis)
• Corporate Insiders Continue to Increase the Pace of their Selling (Mark Hulbert, MarketWatch.com)
• 100-Year Floods are More Common Than You Think (Jonathan, My Money Blog)

…and on an unrelated, but uplifting note: Project Icarus

VXX Surpasses Two Million Share Mark for First Time

As the VIX sinks to a new 52 week low, the iPath S&P 500 VIX Short-Term Futures ETN (VXX) appears to be catching on with investors who are looking to trade volatility directly without going the options route.

Trading volume in VXX topped the two million share level for the first time today, as investors began snapping up the ETN after it fell to an all-time (since the 1/30/09 launch) low of 47.60, then began rising as stocks sold off in the last 1 ½ hours of trading.

With only eight months of data, it is still too early to determine whether spikes in VXX volume represent the smart money or the dumb money, but the chart below is an attempt to lay out the facts so far. To simplify the interpretation a little, I have included a 50 day exponential moving average (EMA) of VXX volume as a purple line in the volume study. I have also highlighted nine of the most prominent volume spikes prior to today, with green arrows indicating where volume preceded a multi-day rise in VXX and red arrows indicating a bearish pattern that followed the volume spike.

Given that VXX has fallen steadily by 50% since its launch at the end of January, it has been a difficult task to time any spike in volatility. With a provisional ‘success’ rate of four out of nine bullish moves coming on the heels of volume spikes, it is also difficult to make the argument that VXX volume has been a sign of the smart money getting long volatility. The chart does show, however, that for a 2-3 day period following a volume spike, VXX is more likely to rise than when there is no volume spike.

Of course, until we get a significant spike in volatility, any conclusions about the predictive ability of VXX volume are going to have to be tentative ones.

For some additional reading on VXX, readers are encouraged to check out:

• VXX Calculations, VIX Futures and Time Decay
• Lost in Translation: VXX and VXZ
• Who Trades the VIX and VXX?
• How to Trade the VIX?

[source: StockCharts]

Where and How to Analyze Treasury Auction Results

Following An Introduction to Treasury Auctions and The Recent Treasury Auction Brouhaha, I have received several requests from readers on where to obtain the relevant auction data and how to calculate the yield, bid-to-cover ratio and percentage of indirect bidders. It would be nice if there were an archived table of all this information, but the table of results for recent Treasury Note auctions omits both the bid-to-cover ratio and percentage of indirect bidders.

As best as I can determine, anyone seeking to capture the history of auctions for a particular bond needs to do so manually. I will quickly walk through how this can be done. First, start by selecting a particular security in the Search by Security Type list at the page with the title Treasury Marketable Security Offering Announcement Press Releases. Selecting the 2-Year Notes will bring up a page with all the data grouped by calendar year. Clicking on 2009 brings you to 2009 Treasury Security Auction Press Releases: 2-Year Notes. On this page, each auction date has three rows associated with it: Announcement; Prelim. Noncomp. Results; and Auction Results.

By selecting the PDF version of the 9/22 auction results, I can pull up today’s auction data. The yield to focus on is the High Yield, which was 1.034% for today’s auction. At the very bottom left, the press release notes the bid-to-cover ratio of 3.23 and provides the source data for the numerator and denominator. Finally, the percentage of indirect bidders is not calculated in the press release, but can be easily computed by dividing the Indirect Bidder – Accepted number by the Total Competitive – Accepted number. Today, that translated into an indirect bidder percentage of 45.2%.

Of course the best way to analyze the numbers is to watch and see how the market reacts to the prices and yields not just for the bond in question, but across the entire yield curve. In evaluating bid-to-cover ratios and the percentage of indirect bidders, analysts tend to compare the current auction to the most recent auction of the same security and to an average of the past 10-12 auctions of that security.

For two superb blogs with a bond focus, I continue to recommend:

• Across the Curve
• Accrued Interest

[source: TreasuryDirect]

Sources for Country Performance

In yesterday’s Chart of the Week: YTD Country Performance, I suggested FINVIZ.com as a source for country performance data.

A commenter was quick to raise some questions about the source data used by FINVIZ.com for their calculation of country returns. Frankly, I am at a loss for exactly how these numbers were derived, though the “U.S. listed stocks only” parenthetical remark has me wondering if the data is derived from ETFs or ADRs.

I can, however, offer three alternative sites for data and charts related to country performance:

• Wall Street Journal International Stock Indices – 13 global indices as well as 59 regional and single country indices, with charts from one day to one year
• CNN Money: World Markets – 27 single country indices
• ETF Screen: Country ETFs and ETF Screen: Regional ETFs – a sortable database of geographical ETFs

Chart of the Week: YTD Country Performance

In this week’s chart of the week, I wish simply to make two points:

1. If you are focusing your investments in U.S. stocks, you are likely underperforming 80% of the global investment world so far in 2009
   
   
2. FINVIZ.com has some excellent summary graphics for geographical and sector/industry group performance and other metrics

The chart below is one such example.

The quick takeaway? Get global!

For some related posts, try:

• Chart of the Week: Breaking Down the S&P 500 Index in Q2
• Equities or Commodities?
• Short Covering Driving Today’s Gains

[souce: FINVIZ.com]

September Expiration Links

I have been largely out of pocket this week, but thanks to my feed reader have been able to keep on top of market developments.

I was going to skip the almost-weekly links post this week, but once again, there has been so much excellent content lately that it seemed a shame not to share some of it.

Two quick disclaimers:

1. I give preference to material that focuses on the VIX and volatility, options, market sentiment, and ETFs
2. While I do not have a bearish bias at the moment, I do find many of the posts with a bearish lean to be more interesting reading

…and on to the links:

• CBOE Volatility Index (VIX) – Implied Volatility, Options Skew, IV30, IV60 at the Crash of 2008 (Livevol)
• Settlin’ Them VIX Options (Tyler Craig, Know Your Options)
• PutCall Ratio – A Blunt Tool (Wayne, Sigma Options)
• Reversion from the Mean (Adam Warner, Daily Options Report)
• The 2009 Rally: Breadth Without Compare (Rob Hanna, Quantifiable Edges)
• The Chinese Silver Download Experience (Gregor MacDonald)
• Baltic Dry Index, Lowest Since May (Peter Boockvar, The Big Picture)
• Making a Case for a Housing Bottom…as Late as 2013 (Dr. Duru)
• Our Asset-Backed Economy (Tim Iacono, The Mess That Greenspan Made)
• What Economists Believe (Grew Mankiw)
• Thorny Questions (Jeff Miller, A Dash of Insight)
• Scott Sumner on the Fed’s Mistakes (James Hamilton, Econbrowser)
• The U.S. Dollar and the Carry Trade Made Simple (Brett Steenbarger, TraderFeed)
• QLeverageSim 1.3 Released (Kevin, Quantum Fading)
• How Quantum Probability Theory Could Explain Human Logical Fallacies (MIT Technology Review)

Comfort Zones, Focus and Thinking Like a Biotech Firm

In Wednesday’s post, Kafka, Surrealism and Trading, I talked about the importance of getting out of one’s comfort zone in order to enhance trading. One reader expressed concern that that pushing the envelope too far and straying from one’s comfort zone was an excellent way to learn some expensive lessons and potentially an approach that invites disaster.

The reader makes some excellent points, so let me expand upon and clarify my thinking.

Consider a biotechnology company as a metaphor for trading and specifically for trading strategy development. A biotechnology firm manages a pipeline of drugs in development and in many cases, also has drugs on the market that are generating revenue. Think of the drugs in the pipeline as analogous to investment ideas that the trader is still incubating, testing and deciding whether or not they have sufficient potential to warrant implementing with trading capital.

For drugs in the pipeline, there are various stages of development before the drugs are tested for efficacy and side effects. As drugs progress through the pipeline, they go through internal gated approval processes known formally as Phase 1, Phase 2 and Phase 3 and eventually through an FDA final approval process that determines whether the drug can be sold to the public. Only a small percentage (approximately 8%) of potential new drug ideas make into pre-clinical trials and less than 1% are deemed sufficient to warrant the investment associated with Phase 1 trials. As drugs encounter the gated approval process at the end of each trial phase, the number of high potential candidates is continually winnowed down, as issues related to efficacy or side effects are subjected to rigorous statistical analysis. As these drugs advance through the pipeline, the financial investment increases substantially. Ultimately, only about 1 in 10,000 of the original drugs involved in the drug discovery process makes it all the way through to FDA approval and ends up on the market. On average, the process takes about ten years.

Investors should look at their investment ideas and strategies as a pipeline management process too. There is limited capital available and only the best strategies should be funded. At the beginning of the pipeline, investors should focus the most attention on getting out of their comfort zone, formulating wild new trading ideas and translating these into actionable strategies. This is the best time to get out of one’s comfort zone and embrace some chaos. As the ideas then progress through some sort of internal approval process, then focus become more important. Is the idea robust? Can the idea be translated into effective strategies? Is there enough liquidity to implement these strategies? What will the slippage costs be? What do the initial backtesting results show in terms of potential? Etc.

As new ideas progress through an internal approval process, the trader should move from an area of discomfort to an area of extreme comfort. By the time a trading strategy is ready to be deployed, the trader’s mind set should have evolved from one of high chaos and low comfort to low/no chaos and high comfort. A corollary of the trading idea development process, which I have sketched out in the graphic below, is that the more one is able to get out of their comfort zone at the beginning of the trading idea pipeline, the better the trading results and the more likely there will be uncorrelated strategies when the chaos of idea generation is translated into focused strategies.

For more on trading strategy development, four excellent blogs to follow are:

• CSS Analytics (David Varadi)
• MarketSci (Michael Stokes)
• Quantifiable Edges (Rob Hanna)
• Trading the Odds (Frank)
  

Kafka, Surrealism and Trading

There are quite a few interesting stories breaking today, but since readers can find most of them somewhere else, I thought I might focus on a story many may have missed that I think is excellent fodder for short-term traders and long-term investors alike.

Science Daily has a thought-provoking piece out today with an intriguing title: Reading Kafka Improves Learning, Suggests Psychology Study. The article summarizes the findings of Travis Proulx and Steven J. Heine, whose Connections from Kafka: Exposure to Meaning Threats Improves Explicit Learning of Artificial Grammar is slated for publication in the September edition of Psychological Science.

Science Daily captures the essence of the research findings as follows:

“The idea is that when you're exposed to a meaning threat – something that fundamentally does not make sense – your brain is going to respond by looking for some other kind of structure within your environment,” said Travis Proulx, a postdoctoral researcher at UCSB and co-author of the article. “And, it turns out, that structure can be completely unrelated to the meaning threat.”

Proulx and Heine’s research demonstrate that subjects who were exposed to literature that was absurd, nonsensical or surrealistic performed much better when tested shortly thereafter for pattern recognition skills than control subjects who read similar material that was easy to comprehend.

So…how does this apply to trading? I am going to stretch the rather narrow conclusions drawn by Proulx and Heine and suggest that traders/investors need to get out of their comfort zones more often. They need to look at new asset classes they are unfamiliar with, new markets, new trading vehicles, new fundamental information, new chart patterns, etc. Perhaps they should even venture out from the comfortable realm of Mozart and Monet to Schoenberg and Dali.

Keep pushing the envelope and don’t worry if new pathways look chaotic at first. The more you get out of your comfort zone, the more that zone begins to widen and the better you will be at recognizing important patterns and opportunities across that zone.

Implied Volatility of 19 Large Financial Institutions: Now vs. 52 Week Highs

Sunday’s chart of the week, which looked at Implied Volatility of DJIA Components: Now vs. 52 Week High, received enough interest to warrant a follow-up that examines the current implied volatility vs. the 52 week high IV of the 19 financial institutions which were subjected to the government stress tests. [link to stress test results]

The chart below sorts the financial institutions from left to right according to their 52 week implied volatility highs, with GM omitted. While not captured in the graphic, I find it interesting that the two institutions whose current IV is the lowest compared to the high IV are Morgan Stanley (MS) at 12.7% of the 52 week high and Goldman Sachs (GS) at 18.9% of the 52 week high. Those institutions whose current IV is closest to the 52 week high (in percentage terms) are BB&T (BBT) at 36.3% and Regions Financial (RF) at 34.6%.

So…going solely on the percentage retracement from implied volatility highs, it appears as if the investment banks are healthiest and have shed the most risk, while regional banks have undergone a much more measured healing process – about what one might expect. Clearly this is a story of multiple different pathways back to financial health.

[source: International Stock Exchange]

Livevol Pro: A World Class Suite of Volatility Tools

Long-time readers will know that when it comes to charts of implied and historical volatility, I have a preference for using free charts from the International Securities Exchange (ISE) and iVolatility.com. In fact, when I started using the ISE Implied Volatility Charts on a regular basis about 1 ½ years ago, I was literally bombarded with requests for information about how readers could create their own charts.

Last November, I chronicled some enhancements to the ISE’s charts in International Securities Exchange Revamps Implied Volatility Charts and eventually went on to recognize these charts as the Best New Free Volatility Tool in the inaugural VIX and More 2008 Volatility Awards.

I mention all of this because the company that developed the ISE volatility charts, Livevol, recently released a new suite of options tools that has now become my personal favorite for volatility and options analytics. Called Livevol Pro, the web-based application was developed by professional traders for both professional and retail investors.

I am glad to have had a chance to spend several weeks with the beta version and was delighted to see Livevol Pro come out of beta this week. If you have an interest in volatility, at the very least you should check out the 5 minute demo movie or the more extensive demo of the full set of features to see what the product has to offer. Among my favorite features are:

• A company tab that displays a comprehensive overview of options data for a selected company/ETF/index, including: implied volatility and historical volatility percentile ranks relative to the last 52 weeks of data; percentage of put and call transactions bought on the ask and sold on the bid; and much more
• An options tab which displays real-time streaming options quotes and implied volatility data – which quickly transitions to level II quotes with built-in options charts
• Options time and sales data which can be filtered by strike, trade size, exchange and date. Included are two years of historical options time and sales transactions.
• A powerful scanning tool with 22 built-in scans that include a number of ways to slice and dice implied volatility, compare IV to HV, track order flow (volume, open interest, ISE sentiment), flag important price changes, and uncover some interesting time spread setups
• Last but not least is a nifty earnings tool that offers two years of a visual history of price and implied volatility changes in the underlying around earnings releases. In the screen capture below, you can see that each earnings period includes five days before and after the earnings release. The graphics track price changes in the underlying (APPL in this instance) on the top row, changes in the value of a straddle position for the front month and second month in the middle row, and changes in implied volatility in the front month and second month in the bottom row

I will be featuring some Livevol Pro graphics and content in this space going forward, but wanted to inform readers about this application, now that it has gone live and is available to the general public. When it comes to options, everyone has their own ideas of what information is important, but for me, Livevol Pro is everything I want, all in one place, and for only $100 per month.

For those who may be interested, Livevol also has a free version of the application available with end of day data that updates after the market close.

For more information, readers are encouraged to visit http://www.livevol.com.

[graphics: Livevol Pro]

Implied Volatility for the DJIA Components: Now vs. 52 Week Highs

As the one year anniversary of the Lehman Brothers bankruptcy rolls around, I can imagine there will be very few celebratory parties.

I certainly have no desire to celebrate what turned out to be my second experience jumping out of an airplane, but I do want to make sure that some of the volatility data from that period are captured here for posterity. At some point in the future, some of us will want to look back and see just how crazy things got in during the historic volatility of October and November.

With this idea in mind, I have chosen to make this week’s chart of the week a reflection on the current implied volatility vs. the 52 week high IV of the 30 companies which comprise the Dow Jones Industrial Average. Of course the DJIA consists of some of the most financially sound companies in the world, so this exercise should highlight companies experienced a less severe impact due to the financial crisis than some of their more speculative peers. In fact, the numbers show that peak implied volatility for these blue chips was, on average, about 3.2 times higher than it is now. Even now, some of these numbers boggle the mind and make a VIX of 89.53 look almost pedestrian in comparison.

Note that Citigroup (C) and AIG were part of the DJIA when Lehman Brothers went bankrupt and subsequently had their membership from that select club revoked. For comparison purposes, consider that Citigroup’s implied volatility peaked at over 328 and currently sits at 66. AIG, on the other hand, saw its implied volatility spike all the way up to 540. It has since fallen to a more benign, but considerably elevated 135. Progress? Perhaps…

[source: International Stock Exchange]

Recent Links of Note

With some excellent content appearing during the last couple of days, I could not help but offer up a new installment in my periodic and highly personal list of favorite recent links, where a strong preference is given to posts that touch on the VIX and volatility, options, market sentiment, and ETFs. As always, informative is good, informative and provocative is better:

• The Impact of Volatility Derivatives (Jared Woodard, Condor Options)
• Comments on a Study of VIX Spikes (Don Fishback’s Market Update)
• Historical Volatility Demystified: Part 1; Part 2; Part 3; and Part 4 (Tyler Craig, Know Your Options)
• Monitoring the Implied Volatility of Your Options Positions (Josip Causic, The Options Insider)
• Stock ETFs, Treasury Bond ETFs, Gold ETFs: How Long Can This Threesome Last? (Gary Gordon, ETF Expert)
• VIX Updated (Biiwii)
• Weekly Overpriced Options Reminder (Adam Warner, Daily Options Report)
• If Sentiment Is Improving on Wall Street and Main Street, Why Are Big Investors So Bearish? (Jordan Kahn, In The Money)
• Inflated Fears (James Surowiecki, The New Yorker)
• Why Are Companies Not Borrowing? (Robert Peston, BBC/Peston’s Picks)
• Q&A: Covered Calls or Collars When Already Retired (Mark Wolfinger, Options for Rookies)
• China’s August Data Confirms Both Optimists and Pessimists OR [alternate link] (Michael Pettis, China Financial Markets)
• What Stories Aren’t Being Told (David Merkel, The Aleph Blog)
• Looking Back: From Peak to Present (James Picerno, The Capital Spectator)
• It’s the Economy, Stupid! (Sudden Debt)
• The Consumer Credit Game Is OVER (Karl Denninger, The Market Ticker)
• Getting It Wrong About Consumer Credit (Hale Stewart, The Bonddad Blog)
• Tracking the Consumption Decline (Menzie Chinn, Econbrowser)
• How Did Economists Get It So Wrong? (Paul Krugman, New York Times)
• 3 In-Depth Views of Flight Delays and Cancellations (Nathan, Flowing Data)

Position Management for SPX Short Straddle

I suspect that when most investors make the jump from stocks to options, the most difficult issue for them to come to terms with is position management. With stocks, it is easy for an investor to reason that if a particular stock rises to a target price of X, he or she will take the profits and exit the position. By the same token, if the stock falls below Y, this means it is time to cut losses.

For options, the process becomes much more complicated. One of the complicating factors is certainly the potential for extreme percentage changes in an option position. It is not uncommon for an option to double in value for several consecutive days; alternatively an option can lose half of its value several days in a row.

Given all the questions I have received about how to manage options positions, going forward I have decided to share some of my thinking about position management using real-time case studies of options trades.

Let me offer up a taste of what I had in mind using a recent short straddle trade on the SPX that I first talked about on August 20^th in The Sideways Play.

First, while I did not go into detail about the rationale for the trade at the time of the original post, one of the technical factors I found appealing was the possibility of the 1000 serving as a consolidation point, with SPX potentially trading in a narrow range that was defined by 978-1018 at the time. The chart below shows that following the initial post (black arrow), SPX subsequently rallied as high as 1040, closing a little over 1030 on August 27^th. When SPX subsequently fell back below 1000 last week, there was reason to believe that the 1030 (closing) and 1040 (intraday) levels might serve as resistance. As described in SPX Short Straddle Still Hugging 1000 Level, the trade had started to yield some meaningful profits at this stage.

[graphic: StockCharts]

Recall from the original post that the short straddle will be profitable if the SPX option settles (on September 19^th) anywhere in the 950-1050 range. At the moment, with SPX in the upper quarter of the profit zone, the biggest risk is a breakout to the upside. I considered the risk to be reasonably well contained as long as SPX did not take out the August 27^th closing high of 1030.98. Leaving a little wiggle room, I set a mental stop of 1032. With yesterday’s close of 1033.37, therefore, I would close half of the straddle by buying back the at risk portion of the position, the calls. Ideally, this would have been done just prior to the end of trading yesterday or perhaps at today’s open.

The graphic below is a snapshot of the position as of yesterday’s close. The original premium was $5000 per contract. At the close of trading yesterday, the position could have been closed out for $3820, yielding a profit of $1180 per contract. This is down from a profit of $1490 a week ago today when the SPX was still hugging the 1000 level. The change in profitability in the past week has been largely the result of directional movement (delta) in the form of a 30 point jump in SPX more than offsetting the time decay at work over the course of the week.

[graphic: optionsXpress]

I see no reason to cover the short put side of the straddle, unless the SPX were to make a sharp move down. Using 1030 as resistance turning into support, one could plan to exit the puts if the SPX were to close below 1030. A lower SPX target might also make sense if I wanted to squeeze out some extra time decay (theta), from the short puts. If I were to take this approach, I would probably use a close (or perhaps intraday violation) of 1000 or below as my exit signal.

Note that in setting up my exits, I am completely ignoring the price of the actual options and prefer to focus on the underlying. In future posts, I will talk about a more holistic approach that encompasses not just the underlying, but also options prices, position Greeks and other factors.

For the record, the previous posts in this SPX short straddle series are:

1. The Sideways Play
2. SPX Short Straddle Still Hugging 1000 Level

An earlier two-part SPX short straddle case study may also be of interest:

1. Is the SPX Going to Stick Close to 900?
2. SPX Straddle Case Study Update

For additional posts on these subjects, readers are encouraged to check out:

• Straddles vs. Iron Butterflies
• One Approach to Volatile Sideways Markets
• The Options Opportunity Matrix

Updating the Triple ETF Options Landscape

A month and a half ago, in Triple ETF Options Landscape, I published a table of all the optionable triple ETFs. Lately I have received several requests to update the data from that post and I am glad to be able to do so today.

As was the case the last time around, I used data from iVolatility.com and separated the ETFs into four groups: broad index ETFs (market cap focus); sector ETFs; geography ETFs; and bond ETFs. I am also continuing my practice of color coding the ETF pairs in terms of liquidity tiers, with green being the most liquid, yellow the next most liquid, and white the least liquid.

At the time of the original post, I also included DRN and DRV, the Direxion 3x and -3x real estate ETFs, which had been launched just a couple of days earlier, on July 16^th. This time around, there are two more entries in the triple ETF stable that have seen very light trading and do not yet have options associated with them. For these reasons, I have not included in the table below the MacroShares Major Metro Up (UMM) and MacroShares Major Metro Down (DMM) ETFs, both of which are linked to triple the percentage changes in the S&P/Case-Shiller Composite-10 Home Price Index.

In terms of investor interest and adoption, during the last month and half the biggest surge in interest has been in the UPRO and SPXU S&P 500 index pair, as well as the DRN and DRV real estate index pair. I have upgraded these pairs to the green and yellow liquidity levels, respectively. The emerging markets duo of EDC and EDZ also continues to gain traction, with options volume that is now on par with the most popular of the triple ETFs.

The chart below includes data through yesterday’s close and reprises the July 17^th data for an easy comparison.

It should go without saying that these are extremely risky investment vehicles, with some peculiar characteristics. Anyone who need a good metaphor to understand just how risk triple ETFs is encouraged to check out Prediction: Triple ETFs Will Revolutionize Day Trading from November 14, 2008, when what now may seem obvious sounded then like the mutterings of a crazy man.

For related posts, readers are encouraged to check out:

• Triple ETF Options Landscape
• Using Options to Control Risk in Leveraged ETFs

[source: iVolatility]

Recent Developments in Gold and Gold Volatility

With the price of gold topping $1000 per ounce today for the first time since February, there has been a great deal of discussion about gold prices and the volatility of gold prices.

While there is no disputing that gold prices are high (today they also matched their 52 week high), the comments I have seen about elevated volatility in gold are not supported by the numbers. In fact, the CBOE’s gold volatility index (GVZ), which is sometimes known as the “Gold VIX,” closed today at 26.97, which is in just the 20^th percentile of the GVZ’s range since the index was launched in June 2008. This means that the implied volatility in the gold ETF (GLD) is not pricing a large move in the commodity in the coming months.

Looking back at historical volatility, the numbers show volatility at historically low levels. A week ago today, for instance, GLD set a new record low for 20-day historical volatility. While historical volatility has risen slightly in the last week, it is still only in the 6^th percentile for HV data going back to June 2008.

A related, but little discussed phenomenon is the correlation between gold and gold volatility. I track this in several different ways, including using 10-day and 20-day rolling correlations between GLD and GVZ. In each of the last three days, the 10-day and 20-day rolling correlations have set new records, indicating that GLD and GVZ have been moving upward almost in lockstep lately, particularly for the past five trading sessions.

The correlation data do have some interesting historical precedents associated with them. For instance, the last time the 10-day rolling correlations set a new high was at the beginning of June, just as gold was topping out just below 990.

In the chart below, I have captured the movements of GLD and GVZ since the launch of GVZ. In addition, I have also highlighted some of the instances when GLD and GVZ have had a persistent negative correlation in the past.

Sometime in the near future, I will pick up the theme of extreme positive correlations between GLD and GVZ.

For additional posts on gold and gold volatility, readers are encouraged to check out:

• Recent Gold Volatility
• Gold and Gold Volatility
• Chart of the Week: Gold
• Three Fear Indicators (or…The Three Baritones)
• The Evolution of the Volatility Family Tree

Stock of the Week ‘Sequential Portfolio’ Update: +466%

I have received so many emails about my Stock of the Week ‘Sequential Portfolio’ that I have decided to start discussing this subject on a regular basis on the VIX and More Subscriber Newsletter Blog. For the record, the subscriber blog is open to all readers and does not require a subscription to access. In fact the main purpose of the subscriber blog is to provide highlights and selected updates from the subscriber newsletter for the benefit of the general public.

That being said, I have had many requests to describe how I pick the Stock of the Week (SOTW) selections and how I track the results, as well as to provide an archived list of all the SOTW picks going back to the launch of the newsletter.

Rather than address these issues here, I have decided to discuss them on the subscriber blog at Stock of the Week ‘Sequential Portfolio’ Up 466% Since 3/30/08 Launch.

Chart of the Week: Peak Hurricane Season Is Here

This year the Atlantic hurricane season has been a quiet one, but that is not to say things cannot heat up over the course of the next month or so.

In fact, as this week’s chart of the week shows, the hurricane season officially peaks in the next few days with the risk of hurricanes and tropical storms remaining elevated through the end of October.

While hurricane season is peaking soon, it is worth noting that there are meteorological phenomena which suggest it is no accident that hurricanes have had very little impact on the U.S. mainland in 2009. Specifically, experts attribute the below normal hurricane activity to El Niño, which developed in the tropical Pacific Ocean during June and has been responsible for increased wind shear in the tropical North Atlantic Ocean and Caribbean Sea, where most Atlantic hurricanes develop.

It is possible that the U.S. – including the Gulf of Mexico oil and gas infrastructure – will manage to elude significant damage from hurricanes this season, but for anyone looking to hedge positions or make speculative plays on hurricane activity, this would be a good week to do so relatively inexpensively.

For some excellent hurricane resources, try:

• National Hurricane Center
• Weather Underground: Tropical Weather
• AccuWeather: Hurricane Center
• Dr. Jeff Masters’ WunderBlog
• National Hurricane Center Archive of Hurricane Seasons
• Hurricane Impact Probabilities Table, by Location

[source: National Oceanic and Atmospheric Administration]

Pre-Labor Day Links of Note

Every time I try a links post, it invariably draws such a strong response from readers that I wonder why I don’t do it more often. Then I remember the two master linkers:

• Tadas Viskanta of Abnormal Returns: most recently, Thursday Links: Trading Slumps
• Charles Kirk of The Kirk Report: most recently, September Signals

There are others whose links I admire a great deal and are updated daily:

• Tim Iacono of The Mess That Greenspan Made: most recently, Friday Morning Links
• Maoxian: most recently, Links for 2009-09-03

Also worth checking out are:

• A weekly list from EconomPicData: most recently, EconomicPics of the Week (8/28/09)
• David Enke of Bull Bear Trader: most recently, In Case You Missed Them – Some Links of Interest

In light of all this, I will endeavor to assemble some of my favorite links and make them a little different by giving a strong preference to the VIX and volatility, market sentiment, options and ETFs. So…with the preamble out of the way, here are some of my favorite recent links:

• Exploring Options Strategies: The Married Put (Josip Causic, The Options Insider)
• Selling Options on Treasury Bonds (Jared Woodard, Condor Options)
• Mutual Fund Cash Levels Updated for Inflation (Babak, Trader’s Narrative)
• TED Spread Update (Scott Grannis, Calafia Beach Pundit)
• Is VIX Too High? (Don Fishback’s Market Update)
• Qs VIX Advantage (Bob Barnes, BZB Trader)
• So What If I’m Wrong? (Adam Warner, Daily Options Report)
• Five Reasons for the Recent Surge in Gold (Jesse’s Café Américain)
• A Look Inside Gold and the GLD Daily Triangle Break (Corey Rosenbloom, Afraid to Trade)
• Exploring Leveraged ETFs and Tracking (Kevin, Quantum Fading)
• FINRA Raises Margin Requirements for Leveraged and Inverse ETFs (Tom Lydon, ETF Trends)
• Q&A: My Personal Risk Management (Mark Wolfinger, Options for Rookies)
• How Overpriced Is the S&P 500? (Michael Shedlock, Mish’s Global Economic Analysis)
• From (Seeming) Chaos, Order (David Gordon, The Deipnosophist)
• August 2009 Rewind – Running on Empty? (Jeff Pietsch, Market Rewind)
• George Ruhana Talks About OptionsHouse (Options Insider discussion thread)

SPX Short Straddle Still Hugging 1000 Level

In many respects the ultimate pure play on declining volatility is a short straddle in which near the money puts and calls are sold simultaneously in hopes that the underlying will move very little prior to expiration. While this is largely a neutral directional bet, it is also a bet on declining volatility.

Two weeks ago today, in The Sideways Play, I outlined some of the logic and details behind what a short straddle trade would look like with the SPX at 1004. Two weeks later, with the SPX down a little more than five points, this trade is a winner. This trade is profiting from time decay (theta), which is currently at -1.20, meaning that all else being equal (i.e., if price, implied volatility and interest rates do not change), the position will gain $120 per day.

Of course, the other variables that affect the price of an option are in motion as well. Options traders use options Greeks to measure an option’s sensitivity to various influences on the value of that option, including the price of the underlying, the volatility of the underlying, time and interest rates.

Specific to the SPX short straddle, the increase in implied volatility (VIX) over the course of the past few days has worked against the options position. The Greek which measures an option’s sensitivity to changes in implied volatility is vega (not a Greek letter, but one that is counted as a ‘Greek’ according to options tradition), which estimates the change in value of an option that would result from a 1% change in the implied volatility of the underlying. In the two weeks, the VIX has increased 2.30 points and as the SPX straddle currently has a vega of 1.61, this means that the 2.30 point rise in the VIX has cost the position approximately $370 during the ten trading days.

While there are other factors at work on this short straddle trade, so far the main plot line has been a story of theta vs. vega, with time decay winning out.

The graphic below shows that a position which originally yielded $5000 in premium can now be bought back for $3510, which would lock in a profit of $1490. With the options expiring two weeks from tomorrow and time decay beginning to accelerate as we approach expiration, it will be interesting to see how this short straddle plays out.

For some related posts, try:

• The Sideways Play (includes profit and loss chart for original SPX short straddle trade)
• Straddles vs. Iron Butterflies

[graphic: optionsXpress]

VIX Spikes Above Bollinger Bands

Yesterday’s 12% jump in the VIX lifted the volatility index to 13.8% above its 10 day simple moving average. As noted on a number of occasions here, when the VIX is at least 10% above its 10 day SMA, this is usually a good time to initiate a short-term mean reversion play and go long the SPX and/or short the VIX.

While I have not discussed it as often in this space, another useful VIX mean reversion signal can be derived from using Bollinger bands to determine when the VIX is overextended and likely to snap back. The simplest approach is to monitor when the VIX closes above the upper band of a 20 day, 2 standard deviation lookback period.

The chart below uses the standard 20 day, 2 standard deviation Bollinger bands to evaluate the moves in the VIX during the past year. Note that following the largest sustained VIX spike ever – during September and October of last year – it has been relatively rare for the VIX to close above the upper band. There was one instance of a close well above the upper band in January that marked a short-term bullish move, then there were two closes above the upper band at the end of February and the beginning of March that preceded the market bottom and strong bounce.

By historical standards, yesterday’s close 4.7% above the upper band is a fairly substantial breach and suggests a short-term bullish bias. Given the narrowing Bollinger band width (bottom study), however, it obviously took a much smaller move to penetrate the upper band than it did in January, when the VIX was hovering around 50.

It seems as if lately everyone has been looking for a pullback. The big question is how much of a pullback it will take to satisfy the bears and how soon it will be until the buy-on-the-dip mentality begins to dominate again.

For some related posts, try:

• The VIX and Bollinger Bands
• More Questions About Bollinger Bands
• Bollinger Bands: Why 20 Days?
• Bollinger Bands and the Standard Deviation Setting
• Charting the VIX with 10 Day SMA Envelopes

[graphic: StockCharts.com]

JunkDEX Falls 11% in First Two Hours of Trading

I was not expecting to talk about the JunkDEX for the third day in a row, but since I have received several requests, I will run with this theme for another day.

Today the JunkDEX is showing an acceleration of yesterday’s 7.2% move downward. As of 11:30 ET, the JunkDEX is down a little more than 11%, with American International Group (AIG), Fannie Mae (FNM) and CIT Group (CIT) all down about 15% each.

Based on the large trading volumes, Sunday’s call of an impending blow-off top is looking as if it may be coming to fruition.

For some related posts on junk financials and the JunkDEX, try:

• JunkDEX Tracks Speculative Frenzy in Junk Financials
• JunkDEX Component Performance

[Disclosure: short AIG at time of writing]