Time to go vega positive?

Cutten · Nov 9, 2003

As Maverick said, taking a position on volatility is basically a directional punt on the underlying. So if you think the S&P has topped, then by all means load up on vol, and accept that you will most likely lose if the rally continues. Personally I haven't found I can make much money by fighting an entrenched market trend. I'd rather wait for it to end and reverse, and then make my move.

As for mean reversion - if the market is transitioning from one secular environment (a stock bubble) to another (post-bubble doldrums), then the usual tendency for vol to return to its short-term mean may be completely overwhelmed by the changing big picture and subsequent secular decline in vol. It's just like trading a stock - buying dips makes money, except in a downtrend

Maverick74 · Nov 9, 2003

Quote from steve46:

Guys:
Based on the posts I am reading here I got to say something. I feel bad stepping up here because anything I say is going to sound snotty or arrogant and that is not what I want. Look, your not up to speed on the basics (everybody). You are competing with floor traders who don't know sh#t, but upstairs is a guy (or girl) who has a PHD in math/computer science, finance, etc and THEY are controlling the game from up there. They have an in-depth understanding of the greeks, stress tested portfolio methods that give them a measurable mathmatical edge, and a lot more money to spend than you do. Finally, when the professionals see the order flow, they have the ability to "squeeze" specific strikes (and you don't). Go back to the basics (McMillan, Nattenberg) or if you think you have it all down, read "The Business Of Options" by Marty O'Connell, or "Dynamic Hedging" by Taleb. If you are sure you have it together, then god bless you, go right ahead and don't change a thing. Steve46
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I am afraid I am going to have to disagree with absolutely everything you just said. Please forgive me.

steve46 · Nov 9, 2003

You might be right. Good Luck.

Trajan · Nov 9, 2003

Quote from steve46:

Guys:
Based on the posts I am reading here I got to say something. I feel bad stepping up here because anything I say is going to sound snotty or arrogant and that is not what I want. Look, your not up to speed on the basics (everybody). You are competing with floor traders who don't know sh#t, but upstairs is a guy (or girl) who has a PHD in math/computer science, finance, etc and THEY are controlling the game from up there. They have an in-depth understanding of the greeks, stress tested portfolio methods that give them a measurable mathmatical edge, and a lot more money to spend than you do. Finally, when the professionals see the order flow, they have the ability to "squeeze" specific strikes (and you don't). Go back to the basics (McMillan, Nattenberg) or if you think you have it all down, read "The Business Of Options" by Marty O'Connell, or "Dynamic Hedging" by Taleb. If you are sure you have it together, then god bless you, go right ahead and don't change a thing. Steve46
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The difference is that what the quant knows mathmatically, many of us know intuitively. I don't disagree, though, that the edge is going upstairs to these guys. I do have a plan(yeah, I've bean saying this for six months). But vol is a different beast, you can make money with some insight that the market hasn't yet jumped upon and quant guys would have rigid rules that won't neccessarily allow them to adjust because their models don't allow for it.

Trajan · Nov 9, 2003

Quote from Maverick74:

Yes, IV is mean reversion but that is not saying much unfortunately. To understand volatility you have to understand how it lives and breathes. Also lets make a distinction here between IV on indexes and individual stocks. There is a big difference. For individual stocks IV does not necessarily correlate with stat viol. I had this argument with Don. It's a very common misnomer. I would almost go as far out to say that stat viol has very little correlation with implied viol. If implied viol was tied to stat viol let's say 100%, then implied viol would be very mean reversion and very easy to trade. However implied viol has a risk component added to it. Implied viol is actually in my opinion more of a risk meter per say.

Let me give you an example. Say stock XYZ is trading at $50 a share. It has a stat viol of 35 and implied viol of 30. Let's also say that the implied viol is in the lowest 1/10th percentile of its implied viol range over the past year making the options look really cheap. Let's also say that stock XYZ is very strong in fact trading at it's 52 week high. It has been in a steady uptrend all year. Well the primary reason why viol is so low is because there is very little risk in this stock. It's very strong and it just keeps trending higher therefore the premium is pricing in very little risk. Say you were to buy these options because of how cheap they are and figuring that viol is mean reversion you decide to buy some long term options on XYZ. Let's also say you are buying straddles since you don't know or don't want to predict the direction of the stock. Well here is the problem you have. Even if the stat viol on XYZ increases the implied viol will more then likely continue to go lower. Why? Because as the stock goes higher the risk is less and less. Also there is a mathematical property at work here and that in simple terms, if the range of the stock stays the same as its rallying, the actual stat viol will drop as the price goes higher. So as long as this stock keeps making new highs and it could stay in an uptrend for years, then implied viol is not going anywhere.

Also something else to add here that many good option traders forget about it, is the relationship vegan has to time. So let's say you buy options that are 6 months out to get a lot of long vegan. And you wait and wait and the stock just keeps going higher. Well, 5 months from now suddenly the stock is downgraded and it starts to come in. Well, you have a pretty bad situation here. Because, the implied viol may have come all the way in to 20 now from 35 so you already took a hit on that but now all your vegan is gone. Why? Because vegan decreases gradually with time. Now your position is ready to capitalize on vegan but you have no vegan left. Instead you have a lot of gamma and a lot of theta. So now your position will gain nothing from the increase in viol but your bleeding profusely with the high theta now. The only thing you can do to save yourself is to hold on to your neg deltas and let your gamma work for you. But then you run the risk of the stock snapping back up and killing you.

BTW, the same scenario plays out on the downside just the reverse. As a stock is falling and the viol is really high, as long at the stock stays in the downtrend, the viol will keep ticking up. It might be statistically overpriced as hell but it's going higher. Again, the same math applies, if the range stays the same all the way down, the stat viol is going to expand every tick on the way down.

So you can understand now why the vix keeps dropping. It's dropping because the mkt keeps going higher and higher and there appears to be less and less risk in the mkt. If the mkt stays in this uptrend for another year lets say, then the vix could go all the way down to 10 or so.

So this creates somewhat of a dilemma right? By actually making predictions in viol you are actually indirectly making predictions on the underlying direction as well or at least you should be.

Back to the relative viol question. As an off floor trader who can pick and choose which options you want to buy and sell, by always buying options that are cheap and by that I would say options where the underlying is weak and not strong but viol has not caught up to it yet and vice versa selling options where the premium is high on strong stocks, you will then hedge yourself much better then just buying cheap viol or selling expensive viol.

I hope I did a good job of explaining to you the concept of volatility. i have met many many option traders and I find that maybe no more then 2% to 5% tops really understand volatility.

It's funny there are so many quant guys out there that get paid so much money to create viol models that I think are so worthless.

If you have any other questions, let me know.
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This is absolutely correct. I suggest people not understanding this from Mav go back and reread until you do. It is fundamental to understanding how to trade Vol. That said, I've been trading long straddles for the past six months with pretty darn good succes. I lean long and let it run before hedging. My losses have been small, but profits big based on 50/50 win/loss. Now you know why I recommended that savy TXN trade.

Trajan · Nov 9, 2003

I would also add, that for as great the quant guys are, there are floor traders who made a living trading against them. I speak specifically of Timber Hill and Arbitrade. People loved trading against these guys because their machine would go off and they would just start hitting bids and taking offers. They gave a lot of free money away, but that's not the point because both made money from engaing in two different strategies..

steve46 · Nov 9, 2003

As I mentioned before, Mav could be right. For myself, I would prefer to stand aside from the equities market. Based on my sense of risk management, It is difficult to get paid well enough to take the portfolio risk. This is a subject that Taleb talks about in "Dynamic Hedging" and I've heard other knowledgeable traders (Paul Wilmot for instance) offer similar comments. I've moved over to the commodities markets. Different game to be sure, but one that a good trader can manage. Also you have a different "volatility signature" (it is possible for IV to rise as price rises for instance). One strategy that makes sense in markets like these is outlined in Gallacher's book "The Options Edge". He advocates selling straddles, hedging with options or futures, on a portfolio of markets (8-10 markets depending on season). He shows you what the edge is, and talks about how to handle the downside (hedging). Steve46

Trajan · Nov 9, 2003

I almost forgot the original question. There was huge institutional demand for Vol leading up to the Iraq war. I forget the exact numbers(I had a lot of drinks when the person in the know told me this), but I trust the person who said this. Now with the war over and the dawning of the bull market we are reverting to the mean or perhaps to low range. In other words, uncertainty is removed and people aren't big buyers of paper which they needed for a hedge. How low will we go? I say look back to the early/mid 90's for a clue. This is, I think, a sweet spot for vol traders as we are able to make rational forecast of future levels. What many people over look is that IV is a function of supply and demand. People were demanding vol because of uncertainty and now they don't, simple. It doesn't mean that long vol is bad trade, but you have to weigh that against what the underlying is doing and put on the right position.

steve46 · Nov 9, 2003

Trajan:
This is one way of looking at IV. Another is the mathematical expression of "persistence". Vol has a way of staying at a level for long periods of time (you probably know that). My comment is simply, if you (or anyone) decide to be long vega, you are going to be subject to theta (rent) and sooner or later, you (the individual trader) will probably find yourself in a position where you can't pay the "rent". On the other side, if you want to sell premium, you can't (my opinion) get paid well enough to make it worth taking the risk in the equities markets. For me this isn't the time to be long options vega. If I want to be long vega, seems to me it is better (easier to control risk, cheaper to transact, better returns) to buy and/or sell equities outright.

Trajan · Nov 9, 2003

Quote from steve46:

As I mentioned before, Mav could be right. For myself, I would prefer to stand aside from the equities market. Based on my sense of risk management, It is difficult to get paid well enough to take the portfolio risk. This is a subject that Taleb talks about in "Dynamic Hedging" and I've heard other knowledgeable traders (Paul Wilmot for instance) offer similar comments. I've moved over to the commodities markets. Different game to be sure, but one that a good trader can manage. Also you have a different "volatility signature" (it is possible for IV to rise as price rises for instance). One strategy that makes sense in markets like these is outlined in Gallacher's book "The Options Edge". He advocates selling straddles, hedging with options or futures, on a portfolio of markets (8-10 markets depending on season). He shows you what the edge is, and talks about how to handle the downside (hedging). Steve46
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Sigh, I don't disagree with you. It would be great if commodities were electronically traded. Equities can be very event oriented which is why I am seeking to be able to diversify. I'm getting leverage so as to put on positions in multiple stocks. I'm right now trading only 1, 2 or 3 stocks at a time because of retail margin rules(often only 1 is actively trade), but I need to trade a lot more to spread risk.