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Showing posts from October, 2017

Equity Volatility is at All Time Lows

Well Maybe…

The author, explaining volatility to the kids of today.
There is no doubt that equity implied volatility is very low. As of October 13th, 2017, the VIX has closed below 10 on 41 occasions. 32 of those days have been this year. As the VIX is popularly known as a “fear index” this situation been labelled a “bubble of complacency” (which sounds like it should be located close to the sea of tranquility). This can be read as putting the blame for low volatility squarely on the shoulders of options’ traders, who actions create the VIX. But this is exactly backward. Implied volatility is low because of realized volatility being a lot lower.
But is realized volatility actually at an all-time low?
Generally, traders don’t have long careers. Bad ones lose their money or get fired. Competent ones see their specialty disappear. Successful ones end up in management. Few traders have any long term perspective. Their idea of history might be as short as five years.
I looked at 20 day …

The Kelly Criterion and Option Trading

(This is based on/cut-and-pasted from a paper that I co-wrote with Reuben Brooks.)
The Kelly criterion can be used to calculate the optimal size of a trade. Specifically, it gives the size that increases the trader's account at the fastest possible rate. It is possible that a given trader might not actually want this. She might want some sort of volatility or draw down constraint as well, but traders should still understand the ideas and implications of Kelly sizing. And misunderstanding abounds.
Generally, traders use an approximate form of the Kelly fraction that only takes into account the first two moments of the return distribution. While in many cases this can be a useful heuristic, when returns are highly skewed the approximation breaks down. In particular, for trades with identical expected returns, the presence of skew can drastically impact the relative sizing of long and short option positions.
Long option positions have unlimited profit potential and limited loss pote…