Googling for Overpriced Options

For most of it’s illustrious trading history, GOOG options by and large have overpriced the Fat Tail risk of GOOG the stock.

Yes there are gaps aplenty here, but almost all came after earnings. For which options routinely get bid up anyway.

Basically a high dollar priced stock looks scarier than it really is.

Now appears no different. We’re seeing options head due north in volatility terms as the stock itself has either stagnant (the ATR and the BB Width) or declining (the blue HV line in the upper graph) volatility, depending on your measuring stick.

The kicker this time is that the stock itself is notably ugly, with it’s Horseman friends like RIMM and AAPL. But it’s an orderly sort of ugly, and a perfect example why Volatility does not equal Downside. Perception is not reality as it is moving at a similar clip to what it did on the rally.

Well, we spend alot of time trying to disabuse everyone from lazy volatility analysis along the lines “20 VIX is cheap” without any context. Clearly a system that involves some sort of Moving Average analysis is preferable, such as the most famous one that says you buy the market when the VIX gets 10% above i’t 10 Day MA and sell it when it gets 10% below.

But that one I find is more guide than rule. And I look at it almost backwards. Instead of using it as a buy or sell signal, I use it as a general health gauge for the market. In other words, if the market consistently fails to bounce when the VIX gets overbought, it’s a pretty bad sign for the intermediate trend, stuff like that.

But what if you refine the metrics a bit, will it gives better directional signals? Jared at Condor Options takes a stab with the BB Bands.

One thing we found is that the standard Bollinger settings (20 period, 2 sigma) weren’t helpful at all. As Bill Luby has pointed out before, indicator inputs are made to be fiddled with, not adhered to! So we optimized a bit, and ended up with a shorter time horizon – the prior 12 days – and somewhat narrower band settings – 1.1 deviations up, 1.8 deviations down. In our test, the system buys (sells short) one contract of S&P 500 futures whenever the $VIX crosses above (below) and then closes beyond its upper (lower) band, and exits when $VIX closes below (above) its 12 day moving average.

And the results?

Going back 5 years, the results are quite positive. Some highlights: this system is only in the market about 50% of the time, but is active enough, averaging 3.76 trades per month. With a profit factor of 2.44 (the ratio of gross profits to losses), and a winning percentage of 66%, there’s some solid positive expectancy here. One of the only unpleasant aspects is the longer hold time and relatively high number of consecutive losers – only an automated system or very disciplined trader will enter that seventh trade after taking 6 consecutive hits.

Going further, he adds the condition that you exit the trade when the VIX crosses back over the midline, you exit either way.

But truthfully, it’s the principle he’s after here, not the specifics. In other words, I would not trade this system religiously. But it is a good confirmation that the whole VIX Mean Reversion we all yap about really has some merit

Some further thoughts on this CXO piece.

Academic papers obviously study problems in a theoretical vacuum. Real world of course differs. I’ve traded options for a while now, and I believe this one gets the gist right. That is, further OTM options provide weaker returns than closer to the money ones. But it may also get the specifics a bit wrong.

Namely, it looks at options as a zero sum game. Which is correct if all anyone every did was buy and sell an option once and never touch it, or do anything against it in the stock or another option. But in reality of course an option owner now has some ammo to fade moves in the stock. He may hedge immediately or he may wait until it gets closer to the money, or he may never do a thing and indeed watch it go to wallpaper.

Let’s say we have a fixed amount of money to risk, and we are deciding between buying fewer, ATM options or a greater quantity or further OTM’s. And let’s say the stock runs, but maxes out at or near the higher strike, but closes such that the ATM’s are now in the money and profitable, but the OTM’s go out worthless. In theory, the ATM’s were the better purchase. But were they in practice? Very tough to know, but I suspect and aggressive hedger would have sold stock too soon against the ATM’s, while that same person may have let the stock rally a bit further before he sold against the OTM’s.

When I was a market maker on the AMEX, basic order flow always got us long buckets of OTM call options. The tendency was always to underhedge them, i.e. not sell as much stock as the models told you you needed to sell. Basically because they didn’t move much up or down until the stock got close, so your risk tended to be hedging too soon, not failing to hedge. Of course I was a market maker in the 90’s for the most part, so stocks tended to all eventually rally, so things may be different today.

But that’s not really my point. What I’m trying to say is the ultimate profitability of an OTM call purchase it likely understated in the study. Not to the point that they are incorrect; OTM’s do not make a good investment, but that underestimates their utility as a trading vehicle,

OK, fool me once…..

The RIMM charts have a familiar ring to them. Sometime high flyer? Check. Very low options volatility? Check. Stock itself not doing a darn thing? Check. Looks just like AAPL, FSLR, GOOG, et. al.

Again, sure seems like a great time to load up on some options gamma, as RIMM rarely gets to these levels.

But like I noted the other day, Time is Money. Every day you own an option where the volatility you paid is higher than the volatility of the stock itself, you cost yourself money in theory (depending upon the specifics of course). The added twist here is that the cheapness is focused mainly in September. October is an earnings month, and volatility is near 50 there, vs. 38 or so in September. I have no position here, Strange as it may sound, if I bought anything here, I would buy it in October. Mainly because with earnings due, volatility is unlikely to decline much before then.

Another warning about trading the VIX. Tradable VIX products NEVER move as much or as swiftly as the VIX itself, with the possible exception of the day before they expire.

The lower chart shows the VIX over the past 6 month’s, while the higher chart shows the VIX Sep. futures (thank you Bill). To line they up, you have to mentally stretch the bottom one. And as you can see, they pretty much move in lockstep directionally.

But if you look closely, they don’t come close to trading in lockstep in terms of magnitude. When the VIX went down to 16 in May, the VIX future only went to 21.5. Likewise the pop back to 31 only saw a VIX Sep lift to 26.50. And those were the extremes, so 15 point lift in the VIX, a near double in about 10 weeks, saw only a 5 pt., or 25% lift in something you could have actually traded. And keep in mind of you bought VIX calls to play for it, results may have been even more mediocre depending on whether you timed it with the correct cycle (June calls for example would have gone to wallpaper before panning out).

I reiterate these points over and over and over again, mainly because this is a very poorly understood product. The VIX is a statistic replete with noise, whereas tradable VIX products smoothe out that noise and assume the inevitable mean reverting tendencies. Now “mean” assumptions of course are not static, so my grander point here would be to always remember if you trade the VIX, you are betting more on where the mean assumptions will go, NOT where the actual VIX might fluctuate to, except very near expiration.

Mark from Options For Rookies makes an excellent point regarding on my thought that in this choppy environment, short gamma players should hang tough and wait for the inevitable reversal one or three days later. That’s an unrealistic trading strategy in the real wold. In fact that’s exactly how Expiration Week whipsaws take place. Short gamma guys “let it ride”, that is let their delta’s move against them in the attempt to save money by not chasing strength and shorting weakness. Then as it goes further against them, they cave and indeed chase or fade. At which point it inevitably reverses in their face and they have to undo the hedge at a loss.

Now I’m generalizing here of course, but Mark’s 100% right. It’s an extremely tough trade to let short gamma fester and hope moves all offset each other.

Let’s say hypothetical Trader X has one position. He is short a bunch of different call and put series in SPY such that has no delta, but is short 500 gamma in there. Meaning for each point up(down) in SPY he gets short(long) 500 shares. And let’s say he collects $400 per day in time decay to carry that position. To make money, he needs to lose less flipping the stock poorly (chasing strength or selling weakness essentially) than he earns on his daily decay. So in this example, let’s say the SPY grinds up 1 over the course of a day, and he covers at the end of the day. He will buy 500 shares on the close, and theoretically lose $250 on his *delta* (he was short an average of 250 shares going up 1 point), but make $400 on his daily decay, for a net profit of $150.

Sounds great, but this is an easy, grindy, non-volatile day. What if SPY gaps up 1 from the open instead. He can sit on his hands, or hedge right then and there. Sit on your hands and it could go up another point before he covers, in which case he’s lost $1000 on his delta, vs. the decay of $400, for a net loss of $600. Or he could hedge and have it go back to unch. in which case he loses $500 on his stock flip, for a net loss of $100.

But what if he notices that moves are all tending to reverse, so he sticks with the sit on his hands approach.

The risk/reward is obvious. He’s been right in 2008 in the sense that moves have tended to reverse. But his risk is enormous if he’s wrong. What happened in January, or March, or July when the SPY got clocked day after day before turning.

The answer is either he hung tough and took massive paper losses before making it all back, or he got squeezed and eventually covered and got whipsawed.

So yada yada yada, yes, unaggressive short gamma hedging was the right way to go in theory. But in practice, VERY VERY VERY tough to do.