Unfortunately, most people are being misled when it comes to Iron Condors. The potential gains are certainly amazing, but the risks are high as well.
Anyone trying to achieve a 5% per month return is likely taking on a lot more risk than they realize.
I’ve heard this story from beginner traders too many times to remember – “everything was going great, I was making loads of money with my weekly condors, and then WHAM, I lost 6 months’ worth of gains in 1 week”.
Those are the risks when it comes to Iron Condors, and the shorter the timeframe you are trading, the more likely you are to suffer a catastrophic loss at some point.
Early February was a prime example. Anyone trading weekly Iron Condor would have been killed.
Short-term Iron Condors have a huge amount of Gamma risk. Gamma risk is effectively price risk.
Trades with negative gamma will suffer from a big move in the underlying stock. Iron Condors as you might have guessed, are short gamma.
Short-term Iron Condors have a lot more negative gamma (or price risk) than longer term Iron Condors.
Let’s evaluate two theoretical examples set up just before the recent selloff.
SHORT-TERM IRON CONDOR
This short term Condor could have been set up towards the close on Thursday February 1st when RUT was trading at 1575.
LONG-TERM IRON CONDOR
This longer-term Condor could have also been set up late on Thursday the 1st of February. Notice that between the two examples, Delta and Vega and almost the same, but the longer-term trade has almost no Gamma.
The trade off is lower Theta as Gamma and Theta go hand in hand.
ONE WEEK LATER
Let’s fast forward to the close of trading on Monday February 12th and RUT has dropped nearly 100 points to 1496.
The short-term Condor has been well and truly crushed and is down over $10,0000.
In comparison, the long-term Iron Condor is actually in profit to the tune of $100!
I hope you enjoyed this case study, if you want to learn more about how to manage Iron Condors, join me for a live training session coming up soon.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. He likes to focus on short volatility strategies. Gavin has written 5 books on options trading, 3 of which were bestsellers. He launched Options Trading IQ in 2010 to teach people how to trade options and eliminate all the Bullsh*t that’s out there. You can follow Gavin on Twitter.
I am here to help you understand how options work, but am at a loss as to where to begin. I’ll explain in the simplest possible language. I am not talking down to you. I am trying to get you to move past a mental block.
Any time that an option is in the money (ITM) at expiration, expect that its owner will exercise. Even when it’s ITM by one penny.
The option owner must fill out and submit a DO NOT EXERCISE form to prevent the Options Clearing Corporation from exercising ITM options
Many beginners do not know they have the choice to not exercise
Many beginners forget they own the options or forget that expiration has arrived. As a result, they become owners of stock that they do not want, and cannot afford to purchase
Many beginners make mistakes. Let’s minimize yours.
Call strike price + premium paid = break-even
I’ve placed your equation in bold. It is of vital importance that you understand one thing about that equation:
This equation, all by itself, is the cause of your problem.
Forget it. It has no relevance on whether anyone exercises an option. Your formula is fine for keeping records, after the trade is closed. It is unimportant now. More than that. It is currently causing confusion and limits your ability to recognize the truth.
Q: Using such a formula, does it follow that when the stock price is less than the break-even, then the call would not be exercised? For example, if at expiration the stock was $15.05 and one had purchased the $15 strike for a $0.10 premium, it seems one would not exercise the option.
No, it does not follow. If you ignored your break-even equation, you would never ask this question. You believe the owner of your call option would throw away $5, just because it represents a loss! Look at it from the perspective of someone who owns 100 calls. They are worth $500 to the trader.
You are saying that it ‘seems right’ for trader would throw away $500 because he paid $1,000 for that investment. No one in his right mind would do that.
To clarify: Have you ever sold stock at a loss? Did you consider telling your broker to take the shares out of your account and to give them to some randomly chosen person? Instead of taking current value for your stock, you could have chosen to make them worthless to yourself. Surely you know not to do that. When taking a loss, you recover some money. Your money. This situation is no different.
You must not toss cash in the trash just because the trade is at less than break-even.
If you lost a $10 bill and the next day found a $5 bill, would you refuse to pick it up because your loss was a larger sum? This is exactly the same. You must understand this principle. I don’t know how to make it more clear. Those options are worth $5 apiece and only an idiot would elect not to collect cash for them. [Exercise is a different decision and trust me when I tell you that selling is better for you.] Whoever ends up holding those options will exercise at expiration.
There is a tiny [my guess is less than one chance in 10 million] that an option ITM by five cents would not be exercised by its owner. But, it remains a possibility. People do make mistakes.
Q: Yet I have read that options will be exercised if the stock price exceeds the strike price at expiration [MDW: this is only true for calls; for puts the stock must be below the strike], which it does in my example. It makes me wonder if there are other factors being considered by the call buyer. One rule, which I assume is adopted by the industry, is that all options in the money at expiration by $0.05 or more are automatically exercised, unless otherwise directed. What other factors could cause calls to be exercised below the break-even detailed above?
Yes, automatically exercised. The OCC does not care about break-even. Nor should you. Today the number is ITM by $0.01, not $0.05.
You want to know what other factors would make someone exercise when that exercise (or sale) results in a loss. Here’s the answer: MONEY.
When you invest or trade, it is inevitable that you will have losses. When you have a loss, you do not have to lose every penny. The trader is allowed to sell (or exercise) to recover some money. You probably understand that process. However, when expiration comes into the picture, you ignore what you know because you think about that break-even nonsense. When you fail to exercise (or sell), you allow the option to expire WORTHLESS. Why would you take zero for an option that you can sell for $0.05? Answer that one question (correctly) and you will understand.
How can the original cost matter? That’s your hang-up. That break-even is bothering you. Today, right now, you have a choice. Take $5 or take zero. It’s as simple as that.
Q: Perhaps my question was misunderstood. I discussed selling the call rather than at what stock price a call owner will exercise. I understand and agree with you that it is better to sell your call for any amount rather than let it expire. I also understand what you mean by saying the premium paid is meaningless. Yes, if your plan was to sell the call and not exercise it then the premium paid is meaningless in terms of deciding whether you are going to sell the call or let it expire.[MDW: If you understand that, then why are you asking?]
(However, the premium is not meaningless if you want to determine if your trading strategy is successful as it represents part of your investment.)
I did not misunderstand. The premium is meaningless, as you admit.
You continue to look at useless items. You think record keeping and evaluating your strategy play a role in this discussion. They play no role when it’s time to make a trade decision. They are used after the fact to see how well you did. [If you disagree, and I have no doubt that you do, that discussion is for another time]
Q: Also, I think you misunderstood my example when I said the stock price was $15.05 and I had a call with a $15 strike for which I paid $0.10. This was interpreted as the stock was trading at $15.10. Perhaps the price relationships I used in my example would not exist in the market. I apologize if I improperly set my example.
When you buy the call at ten cents, and eventually exercise, then you buy the stock at the strike price ($15) per share, but your cost basis is $15.10. You did not improperly set your example. Nor did I misunderstand.
Q: Even so, I am encouraged by how you ended your response: “In this scenario you should almost never want to exercise”. This indicates to me that the risk of owning the stock, plus the additional investment required, must produce a greater return than displayed in the example before exercising the call becomes likely (at least for you).
No, not for me. For everyone. You made an investment. You sought a certain return. You did not earn that return. so what? Today is decision time: You take your $5 or you don’t. ‘Return’ no longer applies.
You are confused because you are looking at too many variables
You are concerned with break-even. You are worried about whether your strategy is working. You think about producing ‘a greater return.’ NONE of that matters at the time when the call owner decides what to do with the options: sell, exercise, discard. You either take the $5 or you don’t. It’s that simple. There is nothing else to consider. The fact that you have irrelevant items on your mind is the reason this is a problem.
Q: I’m still left not knowing at what stock price / strike price combination calls are usually exercised. [MDW: Of course you know. When the stock is at least one penny in the money options are exercised.] I suppose as a buyer it would be when the stock price is greater than the strike price plus the premium. [MDW: NO]As a covered call seller it probably would be best to assume it would be when the stock price exceeds the strike price.[MDW: YES] Although this is not technically correct since a call’s price must be greater than zero to be sold, it’s probably good enough.
Calls are always exercised when they are in the money at expiration. Period.
There may be the occasional individual investor who correctly (for his/her situation) decides that exercising is too expensive because of commissions (and there were no bids when he/she tried to sell the call), but in general, all ITM options are exercised. That is all you or anyone needs to know.
Over the years, if (and only if) you can overcome your mental block, you may not be assigned a couple of times when the option is ITM by a penny or two. Just don’t expect it to happen.
Q: I appreciate your efforts to help me with my question. I’m sure when my covered calls expire next week I will have an even better understanding that can only come from experience. Thanks again.
You are welcome. However, your entire conversation was from the point of view of the call owner. As the call seller you will learn zero about the mindset of the call owner. ZERO.
You must open your mind, throw out your misconceptions, and the truth will be right there in front of you. This is not difficult. This is the easy part. If you cannot understand this, there is no chance you can ever learn to use options effectively.
Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.
So, let’s have a deeper look into those stages and what they really are.
Level 1- The Beginner
This stage starts when you realize there is a way to make money while staying at home. At this stage you are probably neither aware of the dangers of trading nor of where to start looking to understand trading. In this stage you are full of enthusiasm and want to conquer the world. In this stage, you are starting to realise that more money can be made through leverage and you underestimate all of the dangers that trading on margin carries. This is the stage that probably 20-30% of “traders” are quitting.
Level 2- The Student
The second level of trading is the learning period. In this period, you are trying to lay your hands on literally everything that is trading related. This is anything from trading articles, free e-books, hard-copy books to paid courses. You are starting to realize what an immense field trading is and how difficult to grasp it is. In this level of trading you realize that you need to choose the right trading strategy. This should be a strategy that preferably fits your personality. You start asking yourself questions like: Should I be a day trader? Maybe, I will be better off as a long-term position trader or swing-trader. What would be the best strategy to fit in my daily agenda. This is the level where you are also asking yourself- can I do this part time, or I should quite my job to start trading full-time.
This is also the level of trading in which you are jumping from one trading strategy to another. You are too eager to realise that one of your trading buddies has just mastered a different trading approach and you are too excited to try it out. The trader inside of you is not really paying attention to money management or risk management. You just want to make “big bucks” and preferably quick. This is also the stage that probably 30-40% of the “traders” are dropping out.
Level 3- Tenbagger Trader
“Tenbagger” is a term introduced by the famous investor Peter Lynch. It is usually used to describe an investment that grows ten-fold. This is the level of trading, in which a trader has finally mastered how to hold a position longer. He/she are not making the same silly mistakes that they used to before. Now is the time to really shine and start bragging in front of your colleagues and friends. Maybe time has come for you to consider quitting your boring job and working full-time as a trader. Or maybe you can send your track record to one of the prop trading houses and ask to join them. The world is your oyster and you are asking yourself how come you did not start trading earlier in your life. You are tapping yourself on the shoulder and start thinking if time has come to consider other types of investments. Maybe you can re-invest; or possibly you can find another hobby. This is the level of trading in which you are asking yourself the question if you should start your own trading blog and share your strategy.
It is all great until you wake up one morning and you realize that you were exposed too heavily and received a margin call. You feel like it is the worst day in your life. You want to cry (and you probably do) and start blaming yourself how stupid you were. This is the level of trading, in which you are releasing how important risk/money management is and how underestimated in your trading strategy it was. This is also a stage in which another 20-30% will call it a day.
Level 4- The Five Percenters (a.k.a. 5%ers)
15 years ago I read somewhere that only 5% of traders really make it. I am not sure whether this percentage is right or is more like 0.5%. What is really true is that only a fraction of traders do really make it to this level of trading experience. Reaching this level does not mean that you will never fall back. There is no guarantee that you will be a 5%er forever. It means though that you have learnt the ropes of trading and know how to manoeuvre in the deep waters of this ocean. Being a 5%er means that you have showed stronger character than the majority of other players and you can finally tap yourself on the shoulder. But you don’t do it. You don’t do it, because you have learnt the hard way that the more you brag about it or the more excited you become can bode only one thing- losing your 5%er status.
Being a great trader is not a natural talent. It is a skill that traders develop over the years. Being a 5%er means that you not only know where to take profit; more important than that- you know where to cut a losing trade. This level of trading teaches you that to know how to live in the unknown. Trading on this level means that you can watch the screen and still be objective. Being a 5%er means that you can hold a bit longer until price finally reaches your target. On this level of trading you are not thinking about trading systems anymore. You have turned into a risk:reward calculator and a pattern-recognition machine. You are never again afraid of not taking this or that trade. At the same time, you are never too afraid to enter in a trade slightly later. You are just a master trader.
What is your level of trading? Are you sure trading is for you? Trading is a field that makes you or breaks you. Every day is different and you need to be flexible enough to understand that. In this article I shared some of my thoughts about trading in 4 levels. Sometimes being a beginner is closer to the 5%er than you think. Feel free to share your comments in the section below.
About the author:Colibri Trader is a price action trader that is constantly looking for the apha. In the meantime, he does not forget to enjoy life, travel and even mentor other traders. This article was originally published here.
When the loss has been reported, this is how it looked like:
And then the fund suffered another, 54.6% fall to $1.94 a share on Feb. 6—a two-day total decline of 80%. “It may be the biggest two-day drop for a mutual fund ever,” says Gretchen Rupp, a Morningstar analyst who covers the fund.
Like mountain climbing itself, the reality proved far scarier—especially for a fund with “preservation” in its name. “The fund sold naked put options on S&P 500 futures,” says Rupp. “It was leveraged and had above-average margin [borrowing] levels.” A put option is a contract that allows its buyer to sell a security at a specified price, the strike price. This allows the buyer to hedge a position or an entire portfolio; if the price of the security falls below a certain level, the option buyer will at least make money on the option. When an institution “writes” or sells a put option to a buyer, the seller is betting that the price will stay higher than the option price. When the seller doesn’t own the actual securities on which it is writing options, that is called “naked” option writing, and it amplifies downside risk.
Standard & Poor’s 500 option prices are determined in part by market volatility; the more volatile the market, the more likely the option will hit its strike price and become profitable. LJM was betting that the market wouldn’t become too volatile—a strategy known as shorting volatility. “The VIX [volatility index] spike on Monday was the sharpest spike in history,” Rupp says. The VIX more than doubled from 17 to 37. So leveraging the fund’s bet against it proved disastrous.
According to LJM’s prospectus, the fund’s investment objective is to seek “capital appreciation and capital preservation with low correlation to the broader U.S. equity market.” Nothing in that statement proved true on Feb. 5. “This fund should never have been marketed to fund shareholders as a tool for capital preservation,” Rupp says.
As someone mentioned:
"Preservation and Growth Fund". At least they have a sense of humor (but I doubt the investors do).
"Short volatility strategies, selling options and collecting premium, have been critically described as picking up dimes in front of a steamroller," wrote Don Steinbrugge, the founder and CEO of Agecroft Partners, a hedge-fund consulting firm, in a blog post. "They generate very good risk adjusted returns until volatility spikes and then have the potential to lose most of their assets if not properly hedged."
This is not accurate. Those strategies can produce very good returns if used properly.
What most experts are missing is the simple fact that the problem is not the strategy. The problem is leverage. Strategies don't kill accounts. Leverage does.
I did some simulations of how those strategies would perform on Feb.5 without leverage. Using different strikes and expirations, the fund would be down around 10-15%. Not pleasant, but survivable. I can’t even imagine how much leverage they used to be down 56% in a single day.
Another famous case of excessive leverage was Victor Niederhoffer. This guy had one of the best track records in the hedge fund industry, compounding 30% gains for 20 years. Yet, he blew up spectacularly in 1997 and 2007. Not once but twice.
"A year after Nassim Taleb came to visit him, Victor Niederhoffer blew up. He sold a very large number of options on the S. & P. index, taking millions of dollars from other traders in exchange for promising to buy a basket of stocks from them at current prices, if the market ever fell. It was an unhedged bet, or what was called on Wall Street a “naked put,” meaning that he bet everyone on one outcome: he bet in favor of the large probability of making a small amount of money, and against the small probability of losing a large amount of money-and he lost. On October 27, 1997, the market plummeted eight per cent, and all of the many, many people who had bought those options from Niederhoffer came calling all at once, demanding that he buy back their stocks at pre-crash prices. He ran through a hundred and thirty million dollars — his cash reserves, his savings, his other stocks — and when his broker came and asked for still more he didn’t have it. In a day, one of the most successful hedge funds in America was wiped out. Niederhoffer had to shut down his firm. He had to mortgage his house. He had to borrow money from his children. He had to call Sotheby’s and sell his prized silver collection.
A month or so before he blew up, Taleb had dinner with Niederhoffer at a restaurant in Westport, and Niederhoffer told him that he had been selling naked puts. You can imagine the two of them across the table from each other, Niederhoffer explaining that his bet was an acceptable risk, that the odds of the market going down so heavily that he would be wiped out were minuscule, and Taleb listening and shaking his head, and thinking about black swans. “I was depressed when I left him,” Taleb said. “Here is a guy who, whatever he wants to do when he wakes up in the morning, he ends up better than anyone else. Whatever he wakes up in the morning and decides to do, he did better than anyone else. I was talking to my hero . . .” This was the reason Taleb didn’t want to be Niederhoffer when Niederhoffer was at his height — the reason he didn’t want the silver and the house and the tennis matches with George Soros. He could see all too clearly where it all might end up. In his mind’s eye, he could envision Niederhoffer borrowing money from his children, and selling off his silver, and talking in a hollow voice about letting down his friends, and Taleb did not know if he had the strength to live with that possibility. Unlike Niederhoffer, Taleb never thought he was invincible. You couldn’t if you had watched your homeland blow up, and had been the one person in a hundred thousand who gets throat cancer, and so for Taleb there was never any alternative to the painful process of insuring himself against catastrophe.
Last fall, Niederhoffer sold a large number of options, betting that the markets would be quiet, and they were, until out of nowhere two planes crashed into the World Trade Center. “I was exposed. It was nip and tuck.” Niederhoffer shook his head, because there was no way to have anticipated September 11th. “That was a totally unexpected event.”
Well, guess what - unexpected events happen. More often than you can imagine.
But when we give our hard earned money to professionals to manage them, we expect better.
LJM Partners had a solid long term reputation. Till Feb.05. As Warren Buffett said - "It takes 20 years to build a reputation and 5 minutes to ruin it. If you think about that, you’ll do things differently.”
We accumulate information, we learn- buying books, asking questions, maybe going to seminars and researching what really works in trading.
We begin to trade with our ‘new’ found knowledge.
We make profits only to give it back very quickly and then realize we may need more knowledge or information.
We accumulate more information.
We switch the stocks we are currently following and trading.
We go back into the market and trade with our improved system. this time it will work.
We lose even more money and begin to lose confidence that we can even be traders. The reality of losing money sets in.
We start to listen to other traders and what works for them.
We go back into the market and continue to lose more money.
We completely switch our style and method.
We search for more information.
We go back into the market and start to see a little progress.
We get ‘over-confident’ in a single trade and put on a big position believing it is a sure thing and the market quickly takes our money.
We start to understand that trading successfully is going to take more time and more knowledge than we ever anticipated. MOST PEOPLE WILL GIVE UP AT THIS POINT, AS THEY REALIZE REAL WORK IS INVOLVED AND THAT THIS IS NOT EASY MONEY.
We get serious and start concentrating on learning a ‘real’ methodology.
We trade our methodology with some success, but realize that something is missing.
We begin to understand the need for having rules to apply our methodology.
We take a sabbatical from trading to develop and research our trading rules.
We start trading again, this time with rules and find some success, but over all we still hesitate when we execute.
We add, subtract and modify rules as we see a need to be more proficient with our rules.
We feel we are very close to crossing that threshold of successful trading.
We start to take responsibility for our trading results as we understand that our success is based on our ability to execute our methodology.
We continue to trade and become more proficient with our methodology and our rules.
As we trade we still have a tendency to violate our rules and our results are still erratic.
We know we are close.
We go back and research our rules.
We build the confidence in our rules and go back into the market and trade.
Our trading results are getting better, but we are still hesitating in executing our rules.
We now see the importance of following our rules as we see the results of our trades when we don’t follow the rules.
We begin to see that our lack of success is within us (a lack of discipline in following the rules because of some kind of fear) and we begin to work on knowing ourselves better.
We continue to trade and the market teaches us more and more about ourselves.
We master our methodology and our trading rules.
We begin to consistently make money.
We get a little over-confident and the market humbles us.
We continue to learn our lessons.
We learn smaller positions lower the volume of our emotions so we trade smaller and this surprisingly makes us better with our discipline.
We learn that risk management is one of the biggest keys to winning as a trader, we start to understand that big losses will make us unprofitable so we finally trade a smaller and consistent position size.
We stop thinking and allow our rules to trade for us (trading becomes boring, but successful) and our trading account continues to grow as we increase our position size only as our account grows.
We are making more money than we ever dreamed possible.
We go on with our lives and accomplish many of the goals we had always dreamed of. Money is our new tool to do what we have always wanted.
Steve Burns has been investing in the stock market successfully for over 20 years and has been an active trader for over 14 years. Steve developed eCourses and wrote books to help beginning traders survive their first year in the markets. Read this and more from Steve on his blog NewTraderU. The original article was published here.
I have had quite a few requests to present some introductory material on the VIX, so with that in mind I offer up the following in question and answer format:
Q: What is the VIX?
A: In brief, the VIX is the ticker symbol for the volatility index that the Chicago Board Options Exchange (CBOE) created to calculate the implied volatility of options on the S&P 500 index(SPX) for the next 30 calendar days. The formal name of the VIX is the CBOE Volatility Index.
Q: How is the VIX calculated?
A: The CBOE utilizes a wide variety of strike prices for SPX puts and calls to calculate the VIX. In order to arrive at a 30 day implied volatility value, the calculation blends options expiring on two different dates, with the result being an interpolated implied volatility number. For the record, the CBOE does not use the Black-Scholes option pricing model. Details of the VIX calculations are available from the CBOE in their VIX white paper.
Q: Why should I care about the VIX?
A: There are several reasons to pay attention to the VIX. Most investors who monitor the VIX do so because it provides important information about investor sentiment that can be helpful in evaluating potential market turning points. A smaller group of investors use VIX options and VIX futures to hedge their portfolios; other investors use those same options and futures as well as VIX exchange traded notes (primarily VXX) to speculate on the future direction of the market.
Q: What is the history of the VIX?
A: The VIX was originally launched in 1993, with a slightly different calculation than the one that is currently employed. The ‘original VIX’ (which is still tracked under the ticker VXO) differs from the current VIX in two main respects: it is based on the S&P 100 (OEX) instead of the S&P 500; and it targets at the money options instead of the broad range of strikes utilized by the VIX. The current VIX was reformulated on September 22, 2003, at which time the original VIX was assigned the VXO ticker. VIX futures began trading on March 26, 2004; VIX options followed on February 24, 2006; and two VIX exchange traded notes (VXX and VXZ) were added to the mix on January 30, 2009.
Q: Why is the VIX sometimes called the “fear index”?
A: The CBOE has actively encouraged the use of the VIX as a tool for measuring investor fear in their marketing of the VIX and VIX-related products. As the CBOE puts it, “since volatility often signifies financial turmoil, [the] VIX is often referred to as the ‘investor fear gauge’”. The media has been quick to latch onto the headline value of the VIX as a fear indicator and has helped to reinforce the relationship between the VIX and investor fear.
Q: How does the VIX differ from other measures of volatility?
A: The VIX is the most widely known of a number of volatility indices. The CBOE alone recognizes nine volatility indices, the most popular of which are the VIX, the VXO, the VXN (for the NASDAQ-100 index), and the RVX (for the Russell 2000 small cap index). In addition to volatility indices for US equities, there are volatility indices for foreign equities (VDAX, VSTOXX, VSMI, VX1, MVX, VAEX, VBEL, VCAC, etc.) as well as lesser known volatility indices for other asset classes such as oil, gold and currencies.
Q: What are normal, high and low readings for the VIX?
A: This question is more complicated than it sounds, because some people focus on absolute VIX numbers and some people focus on relative VIX numbers. On an absolute basis, looking at a VIX as reformulated in 2003, but using data reverse engineered going back to 1990, the mean is a little bit over 20, the high is just below 90 and the low is just below 10. Just for fun, using the VXO (original VIX formulation), it is possible to calculate that the VXO peaked at about 172 on Black Monday, October 19, 1987.
Q: Can I trade the VIX?
A: At this time it is not possible to trade the cash or spot VIX directly. The only way to take a position on the VIX is through the use of VIX options and futures or on two VIX ETNs that are based on VIX futures: VXX, which targets VIX futures with 1 month to maturity; and VXZ, which targets 5 months to maturity. An inverse VIX futures ETN, XXV, was launched on 7/19/10. This product targets VIX futures with 1 month to maturity. As of May 2010, options have been available on the VXX and VXZ ETNs.
Q: How can the VIX be used as a hedge?
A: The VIX is appropriate as a hedging tool because it has a strong negative correlation to the SPX – and is generally about four times more volatile. For this reason, portfolio managers often find that buying of out of the money calls on the VIX to be a relatively inexpensive way to hedge long portfolio positions. Similar hedges can be constructed using VIX futures or the VIX ETNs.
Q: How do investors use the VIX to time the market?
A: This is a subject for a much larger space, but in general, the VIX tends to trend in the very short-term, mean-revert over the short to intermediate term, and move in cycles over a long-term time frame. The devil, of course, is in the details.
Bill Luby is Chief Investment Officer of Luby Asset Management LLC, an investment management company in Tiburon, California. He also publishes the VIX and More blog and an investment newsletter. His research and trading interests focus on volatility, market sentiment, technical analysis, ETPs and options. Bill was previously a business strategy consultant. You can follow Bill Twitter. This article was originally published here.
VXX invests in a combination of the two front month VIX futures.
VXX keeps exposure of one month in the two front month futures on the VIX. It will invest in the combination of the two forward month futures such that its weighted average exposure is a month. This is how it works.
Today was the expiration of the July VIX futures, so as of end of day today the VXX ETF is fully invested in the August futures. Over the next 5 weeks it will sell a portion of its August futures every day and buy September futures on VIX, to maintain the one month average exposure.
Since September futures are currently trading at around 7% higher than the August futures, each time it does this it will lose a little bit of money, known as the roll yield (loss).
In addition, the August futures is currently about 12% higher than the spot VIX, so that will erode as well, as it must match spot VIX on expiration.
Therefore, as a general rule, VXX is going to decay over time and SVXY is going to rise.
However, traders should not automatically assume going long SVXY and / or short VXX is a guaranteed way to make money. Sure, that trade has worked for the last few years, during a bull market, but it has experience sharp declines. The trade would also get hammered in a bear market.
The reality is, if a trader was long SVXY and it dropped 75%, would they be able to continue to hold it assuming that it would to go over the long run? Maybe if you had $500 invested in it. But, what if you had $50,000 invested in it?
SVXY HISTORICAL DATA AND PRICING MODEL
When researching for this article I found a great spreadsheet that contains historical data for the maybe volatility products (VXX, VIXY, XIV, SVXY, UVXY, TVIX).
The following chart also shows the performance of SVXY since inception, but also the backdated performance based on model data.
Image Credit: Six Figure Investing
You can see that during the financial crisis, SVXY dropped 92.5%. So simply going long SVXY is not a valid investment strategy.
LONG SVXY OR SHORT VXX?
Trading long SVXY or short VXX has the same underlying thesis. The trader is betting on a fall in volatility.
SVXY can only go to $0.
VXX can theoretically go to infinity.
Profits can be made more quickly in VXX which is perhaps why some traders prefer it.
In terms of risk, it is more prudent to go long SVXY rather than short VXX, but both trades can suffer potentially devastating drawdowns.
Here is a great quote from Vance Harwood – “It’s interesting that an investment structurally a winner albeit with occasional setbacks is not as popular as a fund like VXX that’s structurally a loser, but holds out the promise of an occasional big win. It seems that people would rather bet on a correction, rather than the slow grind of contango.”
Seems like the casino mentality is alive and well in the stock market where traders are aiming for that big win, but are generally disappointed.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. He likes to focus on short volatility strategies. Gavin has written 5 books on options trading, 3 of which were bestsellers. He launched Options Trading IQ in 2010 to teach people how to trade options and eliminate all the Bullsh*t that’s out there. You can follow Gavin on Twitter. The original article can be found here.
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Thanks to everyone who shared these great quotes!
Steve Burns has been investing in the stock market successfully for over 20 years and has been an active trader for over 14 years. Steve developed eCourses and wrote books to help beginning traders survive their first year in the markets. Read this and more from Steve on his blog NewTraderU.
This article tells the story of an incredible SVXY trade that was a nice winner despite the total collapse of SVXY.
Few months ago, SteadyOptions introduced a new portfolio called PureVolatility. It is currently part of our SteadyOptions service. The portfolio is managed by one of our veteran members and mentors, Scott Batchelar. Here is an extract from the strategy introduction:
We will be looking to hold constant exposure to short volatility while the curve is in significant Contango in an effort to harvest volatility premium. We will also look to go long volatility when the curve is in significant Backwardation and indicators reveal the trend will continue in the short term. Because the curve is in Contango approximately 80% of the time, we will hold short exposure to volatility most of the time. The main strategy to gain this exposure will be through a Collar spread.
ThePureVolatility model portfolio will be based on total capital amount of $10,000 with a 5% allocation onrisk. This is very important as those who are trading in a Reg-T account would on average need $10,000 in initial margin to hold the position even though the risk may only be $500. Portfolio Margin accounts would only require the $500 max loss amount. Reg-T is somewhat antiquated when it comes to margin for a Collar spread. However, this really should not be an issue because if one does not have $10,000 to put aside for this strategy it is probably not appropriate. Furthermore, the increased margin amount will keep members from over allocating to this very aggressive strategy. We will target a risk reward of better than 1:1 for a two week holding period.
Here is an example of the Hedged Collar strategy sized for the model portfolio:
100 shares of SVXY at 101.93
Short 1 contract of the 11/10 110 Call at (1.35)
Long 1 contract of the 11/10 103 Put at 5.54
Using the above example, here is the P/L chart of the trade:
Please note that the profit potential is around $400 and risk around $300.
For a strategy that wins around 80% of the time, this is an incredible risk/reward.
But it gets even better.
One of our other veteran members posted the following comment on the forum:
I agree with the trade rationale, but had a thought about a tweak to improve the trade structure that I wonder if you considered - that is replacing the 100 shares of SVXY with a deep ITM call, 90 delta or more. I see two main benefits.
Significantly lower the capital requirement while maintaining basically the same dollar increases when the SVXY rises since the deep ITM call will grow in value almost as quick as being long the SVXY shares.
In the event of a large volatility spike where the SVXY would drop in value very quickly, the deep ITM calls would hit a point where they are losing less than the SVXY shares (as that deep ITM strike gets closer to ATM its delta would decrease).
After some discussion, it has been decided to modify the trade and use deep ITM calls instead of the shares.
Here is an SVXY "modified" collar entered on January 30 with SVXY at 114:
I opened a new collar but I'm holding off on selling the call:
BTO 1 March 16, 2018 70 Call
BTO 1 March 16, 2018 110 Put
Please notice how using ITM calls instead of shares allows to reduce the risk if the stock makes a big down move.
On February 2 SVXY started to move down. By the end of the day on February 5, SVXY went down around 40%. After few adjustments the P/L chart looked like this:
The trade was down $750 or 7.5% loss on $10,000. This is completely reasonable, considering that the underlying was down 40%. Any bounce to $90 area should bring the trade back to breakeven.
But then black Tuesday came. SVXY opened around $11, 60% down. The calls became nearly worthless, but the puts were the big winners, far outpacing the losses in the calls:
Overall this trade produced almost 45% gain on margin or 26% gain on $10,000 portfolio.
The bottom line:
A trade that was long SVXY, was a big winner after SVXY went down 90%+. This is options trading at its best. And this is the power of our trading community.
Whatever it was, the VIX went from 17% to 37% in a matter of two-hours, or up 115%. That is the largest percentage gain in the VIX in one day ever recorded.
Even then, while that is a huge move, it wasn't really market disruptive in any great way other than, the market had a bad day. But then the after hours margin calls came in -- and that was an unmitigated disaster for one particular instrument of interest to us: Credit Suisse AG - VelocityShares Daily Inverse VIX Short Term ETN (NASDAQ:XIV).
DON'T LISTEN TO TV
The reporters on television have no understanding what XIV is -- it is not a naked short bet on VIX. No, it is an investment in the core underlying principle of market structures, driven by positive interest rates, known as Contango.
Remember, the XIV is the opposite of VXX, and the expected value of VXX is zero. Here it is, from the actual VXX prospectus:
This instrument is not a radical short trade, it is fundamentally an investment in an ETN that reverses the value of an investment that is ultimately expected to be zero, which made it so good, for so long, and would have for several more decades.
WHEN A LINE BECOMES THE FOCUS
A little detail in the prospectus of XIV is that, hypothetically, should it lose 80% of its value from the close, it would cause a "acceleration event." That means that if the XIV sunk to 20% of its value, it would go to zero and the ETN would go away (and start over later).
Now, obviously, this had never happened to XIV before, but it's only a decade old. When scientists back-tested XIV all the way back to the 1987 crash and including the 9/11 terror attacks, they noted that even then, XIV would not have suffered a 80% decline in a day. But we have never seen such a market with so many naked short vol sellers as we have today.
As a barometer, even as crazed as Monday was, here is how XIV closed:
Down 14.32% is ugly, but, it's just a day -- a bad one, but nothing really all that crazed. Then the after hours session happened, and the best anyone can tell, as of this writing, is that some firm (or fund) had to unwind a short volatility position due to a margin call.
That meant they had to buy the front month expiration of the VIX futures, leaving the second month unchanged. That little detail is everything, because the XIV is an investment on contango -- when the second month is priced higher than the first month. This is a market structure apparatus -- we could call it "normal market structure."
But, with a flood of buying to cover short front month futures, the XIV started tumbling after hours. At first, social media saw it as a buying opportunity. Then it started dropping faster. Then disaster struck.
The XIV dropped more then 80%:
The financial press did its best to cover it, but after a 2 minute segment on CNBC, there was nothing left to say because of one major rule inside the XIV prospectus. Here it is:
In that fine print, it reads that if the value of XIV dips to 20% of the closing value (if it is down 80%), the fund stops. That is, since this trade, if done with actual futures contracts, can actually go negative, the ETN stops itself out at a 80% one day loss. This is why we investors use the ETN, knowing that a 100% loss is the worst that can happen, as opposed to the futures, where much worse than 100% loss can occur.
And the greatest burn of it all
As of Tuesday morning the VIX is down huge (of course it is), the market structure has held (of course it did), and XIV would be having a very good day (of course it would).
But, worse --- it turns out, as far as we know (still speculation), while it's hard to swallow, that the unwinding was done by none other than Credit Suisse itself. Yes, the creators of the ETN had another concern, beyond the assets under management -- and here it is -- -- look at the largest shareholder.
Credit Suisse quietly became the single largest holder of the very instrument it created, and by a huge amount. So, as 4pm EST came around, a bad day in XIV, but survivable, became the death knell, because the largest holder, the XIV's custodian, panicked, and covered.
But, Credit Suisse could not very well just sell millions of shares of XIV in a thinly traded after hours session, so it turned to the VIX futures market.
It appears, as of this writing, that this has actually occurred. While Credit Suisse (the issuer of the ETN) has yet to comment, it appears that whatever this "flash crash" did, whatever margin calls were triggered after hours, the short vol trader was in fact the firm -- it unwound positions in a size that the market has never seen before, and that means that it looks like XIV is possibly going to some very, very low number -- like $0, low.
It's with great regret that as of right now, we do believe XIV is, for all intents and purposes, gone, from a little rule hidden deep in the prospectus that no one gave much concern and that got blasted away when the top holder in the note was the custodian itself.
It's a reminder that the real danger to a portfolio is not a bear market -- we recover from those quite nicely as a nation -- it's the delirium that happens when a bull market gets totally out of control and margin is used excessively in a spurt of just a few days. And by margin, we don't mean normal, everyday investors, we mean the institutions -- even the ones we entrust to be custodians of our investments.
So that's it. XIV likely would have done just fine after this moment in time in the market, will not be given that opportunity to recover. It has been blown out on the heels of yet another Wall Street debacle, which no one seems to even understand, yet.
The author is long shares of XIV in a family trust.
Ophir Gottlieb is the CEO & Co-founder of Capital Market Laboratories. He contributes to Yahoo! Finance, CNNMoney, MarketWatch, Business Insider, and Reuters. This article was originally published here.
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