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Showing posts from August, 2017

I Don't Like Mondays

Actually I don’t dislike Mondays more than any other day, but that is a title that I can get a funny picture to go with.
In the last few blog posts I wrote about how equity options don’t fully account for the weekend and that there is edge in selling on Friday. In this post I’m going to briefly look at how we can exploit the same effect in the VIX.

It is well known that the VIX tends to be up on Mondays. This effect has been consistent, and highly statistically significant, since 1990. The average return by day of the week is shown in Figure One.

Figure One: The average (log) VIX returns by weekday.
There is a structural reason for this. The VIX is based on calendar time. It uses actual days to expiration to calculate the variance swap it is based on. So if an option is priced at 5 on Friday afternoon, and opens at 5 on Monday, the VIX calculation thinks that implied volatility has to have increased because no time decay has occurred even though time has passed.
But the options’ mar…

Theta and Weekends Again

Last week we stated that market makers don't fully account for weekend decay in equity options. Today we show specific results.
Christopher Jones and Joshua Shemesh studied this issue and presented the findings in a paper that they presented to the 2010 American Finance Association meeting. They looked at the returns of long option portfolios on U.S. equities from 1996 to 2007 and found the average return over the weekend was negative (0.62% of the portfolio value) while the returns for all other days were slightly positive (0.18% a day). It is important to be clear what these numbers mean. The 0.62% number means the average option (averaged over puts, calls, and all strikes and maturities) declines in value by this amount over the weekend. This is not the return on equity of a trader holding a short position. This position would need to be secured by an amount of margin that is appreciably greater than the option premium.
Having established that weekend returns are significantl…

Theta and Weekends

A number of traders, some of whom are even successful, claim you don’t need to understand the “Greeks” to trade options. They might have a point. Although the Greeks exist whether or not we keep track of them or understand them, in the final reckoning the option price is what matters. If we buy some options for $1,000 and later sell them for $2,000, we will have made $1,000 no matter why the price change happened. However, understanding the Black-Scholes-Merton paradigm and the associated Greeks is like knowing a new language. Sometimes it is simply easier to express a certain idea in a different language, and sometimes a certain trading idea can be most easily visualized with the help of the Greeks.
Here we will talk about one such trade, based on one Greek: theta. Theta is the change in the option price over a certain time interval if nothing else changes, particularly the underlying price. But over the same time interval we expect the underlying price will change. The amount the …

War and the Markets

I was going to write about the weekend effect in options and the VIX, but this seemed more appropriate. It is a blog post from the now retired (to a Caribbean island) FactorWave blog.

This post is based on an article I wrote for Active Trader Magazine.
"Buy to the sound of cannons, sell to the sound of trumpets." -Lord Nathan Rothschild, 1810

The Rothschilds were one of the world’s richest families and formed a modern financial dynasty. In 1815 they were rumored to have made a fortune when they used a carrier pigeon to send the result of the Battle of Waterloo (which was “a damn close-run thing-the nearest run thing you ever saw in your life” according to the victorious general, the Duke of Wellington) from Belgium to London. Having the news before his rivals gave Nathan an edge over his competitors on the floor of the Stock Exchange.
This is a good story. It isn’t true, but it is a good story. It is true that the Rothschilds were known to use pigeons to communicate (an 18thcentu…

Maybe Markets Aren't Complacent at All

Equity volatility is at its lowest levels since the VIX was first calculated. Since 1990, 26 days have seen the VIX close below 10. Seventeen of those days have been this year, and 10 have been in the last month. One trivial reason for the persistently low VIX is that realized volatility has been even lower. Since the start of July the average VIX level has been 10.26 but close to close realized S&P volatility has been even lower at 5.9%.
This is obvious, but also means that the “option markets are complacent about risk” argument doesn’t hold water. The actual market isn’t moving so no one is going to pay a lot for S&P options or VIX futures in this environment. The real question is, “why isn’t the market moving?”
Prices and volatility are the aggregate of market participants views. If all investors have the opinion that volatility will be large then it will be. But another way volatility can come about is if all the traders have different views of future returns. Here is a v…