When is There Not An Edge to Sell Premuim?

In the financial industry, the likelihood of outlier moves has been a constantly argued subject. This is especially true when it comes to derivatives products, specifically options. How often do the 3 std deviation, 2 std deviation, or even 25 std deviation events occur? Now I do not want to turn this into a mathematical article at all. In fact the way I will look at this just might make a mathematician cringe. However, lets take a look into some of the facts.

1. When volatility is above its mean to is a time to sell volatility.
2. The seller of the options wants implied volatility to forecast greater moves than realized volatility will be.
3. Not all stocks are good products for premium sellers because implied volatility is consistently wrong in predicting the actual moves/volatility.

Therefore, lets take a look at the opportunity this presents us. As we all know, many individual stocks are much more volatile than the stock market indices. This means historically indices have performed well for the short premium side not including some large outliers (i.e 2008-2009 crisis). Despite this, historical volatility tends to stay above implied volatility most of the time. This means volatility is low and continues to contract. The large opportunities in indices come only when there are large discrepancies in the volatility. However, this is looking at it on a long-term level.

However, if we were to expand our range to more range bound volatile indices like emerging and global markets we have more risk, but we have much more decent opportunity of implied volatility outweighing realized volatility.

If we were to sell premium in global indices we would overall have the edge. Even statistically index short premium works (You would especially know if you have ever watched the Karen the Super trader interviews). However, in individual stocks, commodities, currencies, and extremely volatile markets these rules do not always hold true. In fact, we will often see outliers where long premium makes sense. These are often the high flying stocks like TSLA or NFLX. Sometimes they are even commodities such as Natural Gas. However, overall short premium still wins, but the premium sellers (usually me) can get burned severely in these underlyings that have such large moves.

What we also must understand is that stocks/markets that behave this way take a long time to mean revert. For example, TSLA has consistently had a discrepancy of realized volatility being much higher than implied for months (you are looking at weekly charts BTW). It is also the same with NFLX. These stocks are premium buying stocks, and these are stocks that I try to avoid selling volatility in. However, when the discrepancy goes the other way their is opportunity.

This is also how I like to use historical volatility in conjunction with IV Rank. I try to look at both before I make a decision. This is especially true when I try and enter a core position where I plan to be short for a while because their is a large discrepancy. My point in all of this is simply "make sure you being paid for the risk you are taking." I always prefer short premuim and even with "undefined risk", but I don't want to be caught in those scary outliers.

Also, I suggest you read this article from Al Sherbin. It is some very interesting views on AAPL historical distributions.
 
Al's Calls of the Day

Patience in the Options Markets

Trading options is quite a bit different than any other trading instruments. In most trading instruments you are looking for more of a instantaneous profit or loss, or in other words instant satisfaction (instant being more quickly). However, the options markets are much more about the likelihood of the move (volatility) and time.

Options decay with time going by, but that is just it. Time takes time. Traders have to wait for time to go by. This is the opposite for the premium buyer, but this person simply wants to bet on direction, and therefore is not a strategic trader (not necessarily a bad thing if it makes money). However, strategic options traders need either volatility to kick in their way, or time to go by. Both of these takes time has volatility grinds down and theta takes time. With undefined risk these factors tend to come in very quickly because you are taking more risk. However, with spreads you have to be very patient. Most spreads that have defined risk will take much longer for both volatility and time to come in because the trader of the spread is taking much less risk, so they give up the risks that come with being naked(Quiet strange minds!). Therefore, you have to be patient when trading options simply because of the factors involved.

 The general rule when it comes to spreads is MANAGE YOUR WINNERS, and be very patient. However, if you trade with spreads being core positions I would say BE SLOW TO ADJUST TRADES. The trader has to give time to let an options spread work for them, and follow their exact rules. If you take the trade off at 50% of max profit then do that. If you repair the trade be slow to do so; therefore, time can work in your favor while you are waiting.

MA and C Trade

I talked about a volatility pairs trade in my last post, and I got a great response on it. Therefore, I am going to take a look at another one. MA (Mastercard) and C (Citigroup) are two stocks that are both in the banking/Financial industry. Both of their earnings reports have also been released, so there volatility is not pumped because of the binary event risk. However, both their volatilities are at extremes, and these stocks have a correlation of (.63).

As you can see, C has a very high IV Rank, and MA has a very low IV Rank; therefore, they are both at volatility extremes. However, if you look up top there is another indicator that shows both at very different extremes. This is a model I have built that looks into volatility extremes. When the blue line is equal to green the model is telling me that it is more advantageous to buy volatility, and red means it is more advantageous to sell volatility. In this case, the model is looking more medium term extremes, and as shown above MA is a great long volatility play, and C is a great short volatility play. This indicator is what interests me instead of IV Rank when it comes to volatility pairs trades.

Now there were a couple of trades I was looking at to put this on. The first one was selling a Citigroup iron condor (.61 credit) 3x MA, and buying a MA iron condor (1.44 debit). However, I do not like that trade because also like to play these directionally. Instead, I was looking to sell a put spread in C and buying a put spread in MA.

Position I will try to take:
C Strikes: Short 47/Long 45 MAR 14 .75 credit (2x MA)
MA Strikes: Long 77.5/Short 75.5 MAR 14 1.08 Debit (1x)

This overall position is then short volatility and long delta in C. It is also short delta in MA and long volatility. However, I did sell more C put spreads than I bought MA put spreads. The reason for this is I prefer to be overall short volatility when I do this, due to my general short volatility bias. However, I wish to know what the overall position risk looks like, so I understand I am setting up the trade properly. I do this by beta weighting the positions against the SPX, and then looking at what those overall trades look like against an index.

Below is the SPX beta weighted position of C and MA:

I will be looking to put this trade on monday morning. The mechanics for me is to let the trade sit, and find a time to manage the winner, as you can not hedge an already hedged position (it is hedged because it is a pair). However, if you do this trade you have to STAY SMALL! You need to give this strategy time to work for you. GOOD LUCK TRADING!