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Showing posts from December, 2017

Selecting an Index Option Expiration

A few weeks ago, I wrote about  what option strikes were best to sell when harvesting the variance premium. This is part of an ongoing project to find optimal option strategies for volatility trading, hedging and directional trading. As the next step, today I’m going to look at what expiration to trade when selling index volatility.
First, let’s look at the theoretical arguments in the Black-Scholes-Merton world. On average the total PL for an option sold at si when the realized volatility is (the lower) sr is


But it is the way that this comes about that is important to us here. This is actually the sum of gamma profits which occur continuously. In one time step


(Traders usually think in terms of the first equation but this second equation is probably more fundamental as it comes straight from the first term in the BSM differential equation). So instantaneous PL is directly proportional to gamma. And short term (ATM) options have more gamma than long term (ATM) options. So you can ex…

The Crowded Short Vol Trade

It is commonly accepted that shorting the volatility ETNs is a crowded trade. Is this true and what, if anything, does it mean?

First, we need to note that these ETNs are backed by VIX futures which are cash settled and, as futures have no fixed issuance, a traditional short-squeeze can't happen. As the demand increases, the authorized participants can just create new shares. There is no limited supply as there would be with a stock or a physically settled future.

It is also important to notice that all of these volatility products are derivative based. For every short there is a long so we could also say there is a crowded trade on the long side. While current short interest in VXX is about 85% of shares outstanding (compared to a heavily shorted stock like TSLA where the short ratio is only 27%), I can't see this as the root of any problem. If we take into account the futures, variance swaps and options the total short ratio of the volatility market has to be 100%.

The long…