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New York Options Traders Message Board › Summary of the October 23 Meetup

Summary of the October 23 Meetup

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Eric N.
New York, NY
Hello Traders and Investors!

I want to send you a summary of our last meetup and a few words of encouragement about the importance of trading this market.

The general theme is that there is no precedent for the current conditions. This is not like the Internet bubble collapse, not like the crash of 87, not like the S&L crisis, and not like the great depression. No one can give us a template for trading in these uncharted waters, nor is there a historical equivalent to guide us. This leaves us in an uncomfortable position to think for ourselves. I am only half joking here; like most people I find it easier to use templates instead of relying on rigorous thinking. For this reason alone, we should continue trading these markets, as I believe that the experience gained would eventually outweigh the cost of tuition.

Last Thursday we covered a couple of theoretical and few practical topics. On the theoretical front we discussed: (1) put call parity relationship and (2) shortcut calculations for the expected move (by the underlying e.g. stock, future, bond) by using Implied Vol of the options. Both are important for understanding the mechanics of the options markets.

Put-Call parity says that the prices of puts and calls are not independent of each other. They are linked through a so called no-arbitrage relationship and can be expressed mathematically as follows assuming European style options:

Call + Present_Value(Strike) = Put + Stock

In other words, owning a put and underlying stock has the same payoff as owning a call and a ‘risk free’ savings account in which the only deposit is the present value of the exercise price. At expiration the Present_Value will simply be equal the exercise price (strike). You can construct an at expiration payoff table for both sides of the equation and verify that this really holds true. This is why we talk about options being relatively cheap or expensive (not calls or puts being cheap or expensive).

The implied volatility calculations are simple. To calculate the expected move by the S&P500 index in the next 30 days, take the value of the VIX and multiply by the square root of 1/12 (i.e. one in twelve months). This gives you the expected percentage move up or down (yes, the model has the same probability of up or down move). If you do the calculation for the current level of VIX and SPX you should get about a 20% monthly expected move, which is quite unbelievable!

In addition we talked about the following general themes as it pertains to trading:

  • Delta neutral trading and volatility trading strategies are difficult to implement in these markets.
  • Be aware that the vertical skew in puts and calls are not symmetric in a lot of the products (check SPY). In particular, the skew is upward sloping on the puts and downward sloping on the calls. This means that selling put spreads or Iron Condors is quite difficult and not cost effective. Out of the money call spreads are better (only if you are bearish of course) – the skew works in your favor.
  • If you want to establish bullish or neutral, short volatility, theta positive positions you may need to resort to selling put ratios or strangles, which I don not recommend for the beginners due to very large exposure in case you are wrong.
  • One should reduce the size of each trade, as you can get more bang out of less firepower these days because of the vol.
  • Directional trading and intraday trading in futures and stocks is working better for some people as the market tends to trend. Personally I like 5 minute charts as the shortest duration; I found it very hard to trade 1 minute or less.
  • When trading options you should have an opinion on volatility and for long term options (LEAPS) may be even interest rates, not just the direction of the underlying stock. As a matter of fact, the direction of the underlying is one thing that you do not need an opinion on when trading options, although these days this is easier said than done.

In closing, current markets remind me of the documentaries made by botanists who video tape plants for long periods of time and then play back the recording at high speeds. What we see is a birth of a plant, its growth and maturation all in a matter of seconds. To me, this is what it is like to trade in today’s markets. The strategies that typically take weeks or months to unravel, evolve in a matter of days or hours. This is what high volatility does – it fast forwards the ‘tape’. I am watching it closely. The natural experiment we are witnessing will probably not happen again in our life time.

Good luck and stay safe. If you have any questions about any of the topics, please send me an email, or better yet post to the board.

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