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May 17, 2010

A Tale Of Two Options

For contrarian traders looking to short Thursday’s explosive price move in NFLX, two bearish trades had dramatically different success as the price of the underlying declined into the afternoon. As is often the case, you can learn a lot just by watching and analyzing the sequence of events in autopsies of the trades.

In order to set the stage, NFLX closed on Wednesday at $107 and the implied volatility (IV) of the front month at-the-money puts and calls averaged 57%. Options of NFLX are very liquid and were trading with reasonable BA spreads.

By 10:30 AM, NFLX price had risen dramatically to $117.46. For the trader who wished to take a contrarian view, he could have purchased the out-of-the-money May 115 puts, the then at-the-money strike for $4.95. Importantly, the IV was 84%. Another trader who prefers to sell premium, could have sold the slightly out-of-the-money calls, the May 120 strike, for $5 at an IV of 84%.

At 2:00 PM the stock had sold off to $113.96. How did our two traders fare? The put buyer could have sold his position for $5.60 for a net profit of 65¢ on the initial position. The premium seller would have been able to close his call position for $2.70 for a gain of $2.30. Both positions were closed at an IV of around 71%.

What is the explanation for the disparity in the results? The reason is volatility crush. Both positions were initiated at an IV of 84% and closed at an IV of 71%. However the call sale represented a vega negative trade while the put buy was a vega positive trade. Volatility had exploded upwards with the dramatic and sudden price rise.

Although IV is generally considered to be inversely related to price, it is important to realize that it can also spike with dramatic and rapid price rises. The outcomes of these two different trades emphasize the importance of considering IV as well as price when designing option trades.

May 7, 2010

When They Come They Take The Piano Player Too

Filed under: Options Education — Tags: , , , — Dan Passarelli @ 2:15 pm

Thursday will go down in the history of the market as one of the strangest days ever. For students of chaos, it was the perfect but infrequent opportunity to take notes. As we begin to digest the effects of this event, there are some instructive lessons to be learned. While it appears that there may have been some “fat fingers” at work, active traders do not have the luxury of managing positions with the benefit of hindsight. I think it is helpful to discuss what can be expected when encountering such waterfall events.

It is commonly recognized that such dramatic sell offs result in large increases in volatility. For example, today’s market chaos resulted in a VIX range of 24 to 41. This general measure of implied volatility (IV) is representative of large increases of IV in a broad range of underlyings. Because of the remarkable increase in IV, newly established positions which are vega positive are at substantial risk for a “volatility crush”.

What is not as commonly recognized is the dramatic widening of bid/ask (B/A) spreads in response to the dramatic sell off. To deal crisply with such spreads, it is necessary to recognize the concept of implied volatility of each side of the spread. When calculated using the various algorithms of the option pricing model, it is possible not only to compute the IV of the total position but also each of the bid or ask sides of the putative transaction. As a rule of thumb, liquid index based options have an IV spread of 3 points or less. In fast market conditions with rapidly changing price, such spreads commonly become dramatically wider. As an example, following market close on Thursday, the deep out-of-the-money SPX May 940 strike puts are quoted at an 11 point spread. Rampant fear has exploded the normal relationships. For those who need to adjust positions, the slippage inherent in defending positions has increased dramatically.

The world of options is a ruthlessly efficient environment for pricing risk in terms of future expectations writ large with the pen of recent events. Never forget that protection is more efficiently implemented before reaching the perturbations of price that demand its use.