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]