Highly Evolved Vol

Over the last ten years, a number of congress members have been elected on a fairly nihilistic platform, voting against practically any spending bill (unless it buys tanks). This is a good way to get elected but it makes it hard to govern. The government has to spend money. While the Republicans have majorities in both houses, there is a huge difference in political philosophies between members of that party. So the current shutdown was probably inevitable. What does a shutdown entail? Apart from “essential services” (active military, FBI, air traffic controllers etc, and the congressional gym ) federal government functions are frozen, and about 800,000 federal employees will be furloughed. National parks, monuments and the Smithsonian museums in Washington will be closed. Other things that stop are processing of applications for passports and visas, and the maintenance of U.S. government websites. The Internal Revenue Service and the Federal Housing Administration...

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 s i when the realized volatility is (the lower) s r 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...

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%. ...

A few weeks ago I wrote an entry about the historical context of current equity volatilities . The conclusion was that volatility is low (startling I know), but if we compare it to the years from the pre-VIX era it isn't quite the extreme outlier it appears. Since 1950, two years have had lower volatilities (1964, 1965) and four others (1952, 1963, 1972, 1995)  are about the same. But 2017 is unusual in a couple of other ways. First, the ratio of absolute value of return to the realized volatility is very high. Volatility is low but we have actually moved a fair distance. As of mid-October, the S&P 500 annualized return to average 20-day volatility ratio was 3.07 (return of 21.5% and a volatility of 7%). The average ratio since 1950 has been only 1.29. Only 1954, 1958 and 1995 have had higher ratios. Even more extreme is the ratio of maximum draw-down to realized volatility. The average value has been 0.99. So far this year the number is 0.4. The biggest draw-down ...

This is essentially a re-post of an entry from the (now dead) FactorWave blog. It is relevant again because it is the first part of what will be a series on strike and strategy selection. One of the things that make options great is that there are many ways to express an opinion. But this is also one of the things that make options tricky. Just because there are many ways to express an opinion doesn't mean they will all be equally good. Some will be a lot worse than others. Let's assume implied volatility is too high. While there are many ways to trade this, the two simplest are to sell either a straddle or a strangle. Here we are going to compare there two strategies. It is easy to work out the expected profit of an option position. It is just the position value at the volatility we sold at, minus the position value evaluated at the realized volatility. But obviously this doesn't tell the whole story. When selling options our upside is capped by the collected premi...