Volatility Du Jour, FSLR

So that call I made the other day, the one about FSLR options on the cheap side? And if only FSLR could break free of the recent range, they would scream for some options?

Um, not so much.

Stock races through and the rush commences. Let’s see who can sell volatility down the fastest.

This chart does not reflect the actual action in the Junes as the ATM’s closed yesterday at a low 50’s volatility.

A couple anecdotal observations about frothy sort of stocks like this. The stock lifts abate during upswings in volatility, not implosions. At least that is my experience. Right here right now the “obvious” trade is to go long some gamma, maybe long calls vs. short stock on a ratio. They tend to stop rallying however when that trade becomes difficult and the board makes you pay up.

Just to clarify a couple things from earlier as Interleague play is upon us.
LEAPS and/or any option with lots of time left are very much a bet on future option volatility and not a particular bet on stock volatility. Buy them and you do not get much gamma, and thus not a whole lot of ammo to flip stocks. You will often see a directional move in your favor get offset by an unfavorable move in option volatility.

Consider long LEAP positions the last couple month’s. Unless you had a pure directional bet on AND did not hedge much with stock, you did OK. But otherwise, the absolute pounding in volatility made it a very challenging trade.

Shorter term options are pretty much the opposite. Yes the volatility of the option can and does fluctuate and will cause your marks to bounce around. But for the most part, your bet is on the volatility of the actual stock, and how you manage it.

So if you are of a mind to buy options, think about the “bet” (or hedge) you want to make.

So got this question yesterday.

Correct me if I’m wrong, but the lack of volatility (ie. low VIX) has the greatest effect on the longest of options, yes?So, in truth, we should be getting drunk and buying LEAPs here, no?

My answer is yes and no. On the LEAP part I mean, lol, I drink about the equivalent of a 6 pack per calendar year.

He is correct in that a LEAP will react more to any identical move in volatility than a shorter term option. Take the SPY for example, a June ATM option now has about a .18 vega, meaning that for every one point move in volatility, the option price will move 18 cents. A Jan09 LEAP however has about a .43 vega, or 43 cents for a 1 point move.

But here’s the catch; volatility in LEAPS does not move nearly as much as near term options.

This chart shows normalized 30 day volatility in SPY, essentially what the VIX tries to capture. It has had about an 11 pt. drop, peak to trough, in the past 7 weeks. The chart here is for normalized 6 month options (as long as ivol. let’s me go) and the move there was more like 6.5 points peak to trough.

So net/net LEAP-ish options have indeed done worse in the volatility crunch than nearer ones, although keep in mind the nearer one’s decay faster. Throw it all together and it’s probably close to a wash.

But we’re not here to talk about the past. What about going forward?

Well, believe it or not that move down in the longer option is way more extreme imho than the clipping in the nearer one’s. Longer duration options rarely move this swiftly. Now of course they likely got overpriced in the March panic, but still……

The shorter the duration on an option, the more you are betting on actual stock volatility and the less on how the volatility of the option behaves. The longer the duration, the reverse. So if you feel stocks themselves are about to get volatile, near terms are better. If you just feel options got too cheap, you want to own LEAPS and the like.

CNBC’s Portfolio Challenge off to another flying start.

Due to technical difficulties related to currency trading, we have cancelled all currency transactions submitted throughout Monday, May 12th and currency trading is currently unavailable. All traders’ currency allocations will be reset to $100,000 CNBC Bucks until currency trading resumes.

Hat tip collegetraderJason in the comments.

And back to the VIX.

16 full as I type, Roger Clemens might even touch it here. At the risk of belaboring the point, check out Sep options. The forward price (effectively the future price) suggests the market still expects the VIX to be 22 on September expiration day.

It is all about mean reversion, but as my insane friend Bill at VIX and More notes, “mean” is very tough to define.

Since much of the discussion of the VIX centers around 10 day moving averages, I thought I would zoom out a bit, pull up a VIX weekly chart, and look at some long-term numbers: the 40 and 200 week simple moving averages (click thru to see).

Logically, one might assume that most of the activity in the VIX would fall neatly in between the 40 and 200 week SMAs. Interestingly enough, that has rarely been the case historically. During the past five years, for instance, the VIX has traded in the range between the 40 and 200 week SMA less than 20% of the time, as the VIX has trended down, then back up.

At current levels, the VIX is near the halfway point between the 40 and 200 week SMA, perhaps partly due to some of the gravitational effect of mean reversion. While current levels of volatility appear to resonate as too low for some, a continuation of the bullish bounce off of the March lows should send the VIX back to the 200 week SMA – or even lower.

In sum, while long-term VIX mean reversion does have some analytical use, it is less reliable than the short-term mean reversion patterns that are more commonly utilized for trading.

The most common short term mean reversion indicator is the 10 Day MA. Any time the VIX gets 10% below (above) it’s 10 Day MA, the VIX is considered oversold (overbought). By this definition, the VIX is oversold now, And since the VIX basically moves in opposition to the market, it suggests the market is overbought by this metric.

Now the caveats.

It is expiration week. Moves in motion tend to stay in motion. Anecdotally, that can last until about Tuesday of next week.

Also, oversold VIX does not provide as good an indicator as overbought. Outright Fear tends to lead to big turns, outright disinterest can just linger.

The VIX estimates volatility on the SPX itself for the next 30 days.

VIX futures are a bet on where the that estimate will be on the day the future expires. In other words, it is a snapshot of what the market expects for volatility 30 days AFTER the future expires. If it is a September future for example, you are guessing how the market prices volatility 30 days forward from September expiration. You are not betting on SPX volatility between now and September, that is a common misconception.

VIX options are cash settled, meaning you get delivery of nothing, just a debit or credit. They are also European exercise, meaning you can’t do anything other than trade them between now and expiraiton.

They price off the futures, NOT the VIX you see on the screen. And since futures carry premiums to the VIX when the VIX has an extended decline, VIX calls here look fat to the naked eye that only compares them to the “cash” VIX. The reverse is true when the VIX runs high; VIX calls can and do trade under parity and puts looked pumped.

Of course moves in the cash VIX have some effect on VIX futures and options, but the further out you go in time, the more limited that effect. Think of this weather analogy. A hypothetical October Weather future let’s you predict the average temperature in Al Roker’s 5 Day forecast on October 15th. Would an unseasonably warm or cold day today effect your prediction of his prediction? Not a whole lot. Same way a move in the “cash” VIX should not have much impact on your prediction where traders will price volatility looking forward in October.

So bottom line; trade VIX options and you are trading a derivative (the option itself) on a derivative (the VIX future) on an estimate of a derivative (the VIX itself is merely a statistically calculated estimate of a theoretical SPX option with 30 days until expiration).

OK, I will say it for the umpteenth time; don’t play the VIX options unless you understand them. And even then, don’t play them. They are an incredibly tricky product and not designed for anything the 99.9% of us who don’t manage large derivatives desks really need.

I saw this in a comment in a Slope of Hope thread.

VIX , none of the JUNE options look they are priced right. Maybe next week VIX JUNE calls will be lower priced.

Trust me, I do not blame or seek to mock the commenter one iota for this. I saw essentially the same misconception from an options “expert” yesterday.

But no, VIX June options are priced correctly, they just align with the VIX June future, NOT the actual VIX. And they are European exercise.

Volatility always assumes mean reversion, often incorrectly. Right now, with options baked, mean reversion assumes the VIX goes higher. So ergo all VIX futures trade at premiums to the actual VIX. And since options price off the futures, all June calls seem too high to the naked eye, and all June puts seem too low.

Again, if you consider the market too high and/or volatility too low and want to fade “cheap” options into the morass, use options on actual stocks/indices/ETF’s. My personal preference right now is something that expires in the Fall.