Every options trader knows about or at least of the Black-Scholes-Merton (BSM) pricing model. Because it is the oldest formalized pricing model and only the first of many, some traders regard it as outdated and inferior. Perhaps it is a victim of the familiarity that breeds contempt. But a recent paper gives some reasons why traders should give BSM a second look.
Delta hedging is an essential component of any volatility trading strategy. When straddle buyers also buy…
Here are some observations about volatility and market conditions.
1. Option implied volatility is not especially high. With all the noise in the markets, you might think that options prices have baked in a lot of downside risk. They haven’t. One month SPX historical volatility is about 18%, and one month at the money implied volatility is closer to 20%. If we add in out of the money skew, VIX-style, we get an estimate of 23.5%. That ratio of implied to historical –…
Implied volatility (IV) skew is one of the most important and interesting aspects of listed options. IV skew typically refers to the differences in the implied volatilities of options in the same expiration cycle with different strike prices. There have been many attempts in the academic literature to model the behavior of changes in skew, but the interpretation of skew information by traders is still done largely on a qualitative and ad hoc basis.
In “Quantifiable Implied Volatility Skew,”…
The jargon of options trading sometimes turns people off, and maybe “volatility skew” is one of the biggest hurdles. So I’m going to explain the concept in a straightforward way, and then explain why volatility skew is something you should care very much about.
Volatility skew usually refers to the difference between the implied volatilities of options at different strike prices in the same expiration cycle. For the majority of stocks and indexes, options with high strike prices have low…
Risking capital is like making a statement in a language. In a natural language like English or French, asserting some proposition puts you at risk of being right or wrong. If you say true things over and over, people will respect you more; if you constantly assert obvious falsehoods, no one will take you seriously. In the language of financial assets, expressing some view means risking your financial capital instead of your social capital: if your financial assertion is wrong,…
I’m excited to announce the publication of Options and the Volatility Risk Premium, a short eBook (about 4500 words) published by FT Press. I have written about the volatility risk premium (VRP) before on this blog, and published a feature article in Expiring Monthly last year on the presence of the VRP in commodity options.
The first part of the text explains the concept of the volatility risk premium and gives a rationale…
Several clients mentioned the sizable decline in implied volatility yesterday and characterized current levels of IV as too low to sell. I think I can sympathize with that intuition – after all, we’re closing in on the lowest levels seen since May, and 18% IV won’t strike most volatility traders as an obvious selling opportunity. To get a snapshot of the current level, let’s take the average of the eight nearest to the money strikes in December SPX options, as…
In addition to the regular performance data, I have a couple of interesting items to comment on for this quarterly review. First: for anyone who thinks that global equity markets may have some choppy periods ahead, this is an excellent opportunity to start thinking seriously about the role non-directional strategies should play in your portfolio. Second: we’ve added a dynamic delta hedging component to the newsletter to improve the purity of our volatility trading and to reduce unwanted…
Considering the spike in implied volatility during the July options cycle, followed by an equally sharp drop—and then by another significant rise in August and fall (no pun intended) in September—it was relatively smooth sailing for our Calendar Options newsletter in the third quarter. We continued to outperform the S&P 500 and keep a respectable pace with the VTY. Our returns since inception and for the trailing twelve months continue to overwhelmingly outstrip those benchmarks, with comparable risk on a…
Standard accounts of the option Greeks will explain that delta measures the rate of change in the price of an option per unit change in the underlying asset. The text I use with mentoring clients, Natenberg’s Option Volatility and Pricing, provides some additional helpful ways of thinking about delta:
as a ratio of underlying contracts to options required to establish a neutral position, e.g. for every five 40-delta calls purchased, two underlying contracts (or two hundred shares of…
Thursday, December 6, 2012
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