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August 25, 2011

Interesting and Volatile Times

“May you live in interesting times” is an ancient Chinese curse. The fact that the last few weeks have seen neck snapping and wild changes in volatility, I think we qualify for living in what these philosophers would consider to be interesting times.

For those who are unfamiliar with the impact of volatility on option trades, suffice it to say that the current market contains unique challenges. As I write, the volatility environment has experienced remarkable volatility. While the concept of the volatility of the volatility may seem arcane, it has huge impact on the behavior of option positions.

Remember that option premium, while quoted as a single bid/ask spread, in reality consists of the sum of the extrinsic and intrinsic premiums. While the intrinsic premium may vary wildly in such markets as we currently are experiencing, it is a straightforward and transparent calculation depending solely on the current market price of the underlying and the strike price under consideration.

The extrinsic premium is not so straightforward and is impacted by several factors, the most important of which are the time to expiration and the IV. The time to expiration is clearly defined by anyone with a calendar, or perhaps a stopwatch currently, and represents another transparent variable.

The situation is much more interesting in the world of IV. This is where current unprecedented directional movements impact option prices most dramatically. The situation is rendered even more complex by the fact that the IV changes are occurring in both directions; it is not simply a trending volatility environment. The volatility of the volatility has increased dramatically.

Traders must be cautious when establishing new positions and monitor the vega of the position assiduously. In many cases, structured positions such as vertical spreads are indicated in order to reduce vega exposure.

August 18, 2011

If I’d Meant That, I’d Have Said That

To the new option trader, it often seems as if he has entered into the terra incognita of the derivatives world through Alice’s looking glass. Engaging the natives in conversation quickly results in encountering colorful characters who appear not to recognize the same reality from which the traveler has arrived. For those who have chosen to enter this new world, Alice’s conversation with Humpty Dumpty seems particularly familiar wherein he declares: `WhenIuse a word,’ Humpty Dumpty said, in rather a scornful tone, `it means just what I choose it to mean — neither more nor less.’

The nomenclature of options is boundlessly confusing. While the casual visitor may only notice the broad categories of puts and calls, the serious student soon will come to realize that the detailed nomenclature is confusing and results from the inescapable fact that options have more moving parts than do stocks. When initiating a stock position, the choices are two: buy or sell the issue. When initiating an options position, the choices are numerous and not mutually exclusive. The selection of the particular series to trade and the anatomic structure in which to place it is often nuanced.

An individual option’s value is a function of three main factors: price of the underlying, time to expiration, and implied volatility. Furthermore the individual options can be combined into complex spreads composed of multiple positions in an almost limitless variety. It is from this abundance of choice that the word salad of option terminology arises.

I find the terminology paradoxically to find its maximum point of obfuscation when used to describe one of the basic building blocks of options, the vertical spread. Verticals represent a two-legged category of spreads in which one option is bought and an option of a different strike is sold; both positions are taken in the same series month and in the same type, either puts or calls. Strike selection determines the directional bias of the trade as well as the credit or debit status. Bullish and bearish trades are easily constructed in both puts and calls.

This simple spread results in a chaotic and confusing panoply of names including: bull call spread, call debit spread, bear call spread, call credit spread, bear put spread, put credit spread, bull put spread, bull call vertical, bear call vertical, bull put vertical, and bear put vertical. As if this collection of a dozen names describing four basic trades were not sufficiently opaque, many traders use an implied shorthand description. For example, they may refer to opening a call credit spread as “selling a call vertical”; conversely opening a call debit spread is often referenced as “buying a call vertical”. The directional bias of the trade is apparent to those having been shown the “secret handshake” by the spread type, call or put, used and the credit or debit status of the opening cash flow.

Unfortunately there is no easy resolution to this nomenclature nightmare. Various traders use the terms inconsistently and variably for no apparent logical reason. Such is everyday life in the world of options.