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Convexity – It’s Evil Too
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Convexity – It’s Evil Too

by MoleApril 13, 2012

So I (volar) do not have much to say for a market outlook- though the VIX 8 day stat worked out well (with hindsight and inductive reasoning bias).

Banking coin is never easy- but avoiding stupid decisions really makes the difference. Convict keeps it simple- and frankly that is why he is solvent.  Solvent traders have a better probability to make coin than the insolvent ones (law of large numbers- just saying). This post is not simple- and will be difficult for a non-options skooled persons, but it should at least give one reason to not stick one’s private parts in a blender (e.g. trading options without the proper tools/knowledge).

I figured this would be one of those informational/discussion threads. THIS IS NOT  ACADEMIC- this is real world options trading. Option theory and retail option platforms- yes even TOS- are “cool,” but they will still FUBAR your account.

I am first going to list some caveats for retail platforms and general option trading fallacies- many of which are found in one of my favorite math reads, Dynamic Hedging. Following that, I will discuss them- of course- that means charts from Volar.

Caveat A: SPX options are not the same as corn options.

Caveat B: Option skews, smiles, and decay term structures will rape you.

Caveat C: Not one, not a single greek, can be compared to another greek- even on the same commod on the same contract. This is a function of the “shadow greeks.”

Caveat A:

What do I mean? Well first off each market will have a different smile- smiles affect option valuation paths. Secondly, and most importantly, IV is correlated (inversely) to price in SPX. This is why I have talked about call rape- but its more than that.  Also SPX has no “carry” trades or spread trades, consequently, the only spread trading with options in the SPX is VOL time structure (think VIX/VXV). Whereas corn, spread trades do matter…spreads do change, and IV is not inversely correlated to price. Many do not understand that most commodity volume is actually spread volume (eg short JUL, long DEC). If you are playing options in a market where spreads move- you better be careful. A risk reversal calendar spread may have the correct direction, but horrible outcome due to shadow greeks. Even on the SPX, where there is no real spread changes, calender spreads (to capture net short theta, long vega positions), still cause havoc for traders without appropriate tools and experience.

Bottom line for caveat A: you have to have a model for each instrument. If your model does not account for correlations and spread differentials- well you are dead in the water.

Caveat B: Option skews, smiles, and decay term structures will rape you.

This chart is Corn IV over time. Clearly nothing is linear here. Notice that anything less than the 80% IV in the put tail of the first chart is not even readable in the second chart.

This chart is near expiration- yikes.

So my point is that the “VIX” is and “average” but averages the curve. The curve changes options differently. This is the largest reason for novice options traders failing- especially when they use TOS or retail option platforms. Sure your platform may give you a greek number, and even allow you to shift VOL, Time, and Price, but it wont model the IV smile term structure/decay.  Toyota has breaks and a gas pedal, but it is not a Ferrari. Even if TOS did model IV term-structure/smile decay- how could you trust it when we know that each commod is different?

Caveat C:

The smile affects option valuations over time.  This is where things get hairy- shadow greeks. All retail models use BSM (black scholes merton)- but none account for the curve.

So let’s say one is short a JUL corn call (say 750 handle today). Delta may be -0.10 but that value only holds for today- technically for about 5 minutes. A typical model, presuming no change in price, will make about 3 (priced near 4 today) with 5 days till expiration (45 trading days from today). However, when adjusting for the smile (aka what volar code does), one will lose 3 cents. This is a 6 cent or 100% difference in valuation. Why? real world vs. academics.  The IV for tails rises- there is no free lunch. Smiles occur for liquidity and “non- normal” distribution reasons. In any case, nobody holds till expiration, yet they make decisions as if they were holding till expiration. If one do not hold till expiration, one will not get expiration results. Many times OTM options (sold) will make one most of one’s money in 1 day- and waiting till expiration to capture a penny usually ends badly due to bid-ask differentials and IV premiums. Bottom line here- if one’s model does not adjust for reality.. one loses coin.

Now to further talk about how greeks are not comparable… spread trades… again.

Many think front month contracts decay more than back month. Some think the back months have more premium to sell and front months are relatively cheap. Neither is correct or wrong. Both are worthless ” all encompassing” statements- like most CNBC stuff.

A good option model should cover sensitivity to the following:

Here is the dilemma.  Is one analyzing 1 day or 1 month? The changes are not linear and they change each other. And each change is multiplied by each other (negative or positive). Yes this looks like crap- but notice that delta is the linear slope of 1 point (chart  below). This chart shows that vega moves opposite to decay, and that up gamma is not the same as down gamma. Also a gamma changes on a vol spike or time decay.

Ok so you see delta only matters at (1) a point in time (2) at a particular price (3) given a certain time (4) given a certain IV (Vol)

Now let’s look at an IV spike:

You can see the Curve is less steep, thus the gamma (delta change) is reduced.

Here is a time decay shift:

So… this goes to show that things change. Gamma up is not the same as gamma down. And gamma up for an OTM is utterly different than gamma down.  Gamma (delta sensitivity) is inverse to Theta (time decay). The math is 1/2* gamma* (vol)*(Contract price^2). This implies that not ALL front month options, when adjusted for the IV curve structure, will not decay (example above). Secondly, one is exchanging decay risk for price risk.

Consider this with 2 options on two different contracts- each has about 20 moving curves at different rates.

This means one must manage the shadow greeks (bleeds, dvol dtime, ddelta dvol, etc…). Below are the ones I follow on a spread trade. BUT one must adjust this for the IV curve. So when I input the trades I know all of the shadow greeks and I model the IV curve. Also remember the spread may not move 1:1 with front month price….

Below are a list of Greeks and bleeds (or changes to greeks for a list of options). In all reality, scenario analysis encompasses all of this into one value, but one must be able to see what and why things change.

No, retail models do not do this correctly.

I suggest using heat maps for calendar spreads- once one adjusts for the code/IV smile of course. Here is a scenario map for 1 particular point in time. When one starts to analyze options, correctly, they will find that scenario analysis is the most optimal choice.

* test the good, the bad, the ugly. Never test the great. Stay frosty.

The top is the contract spread (JUL- DEC corn), the left is CN (JUL corn).

Here is 2 different vegas (price sensitivity to change in IV) for a JUL , DEC calender corn spread. Notice that front month VEGA declines relative to DEC. This means that those who “think” deferred options carry more “premium” is bull crap. The greeks are less sensitive- even though our above example showed that the IV smile spike/shift offsets the decay.

This means one must learn to trade the greeks and shadow (future) greeks. If one plans out the option scenarios one will find that most “common” ideas from brokerage houses are stupid.

So differed options have less sensitivity, but the gamma is higher and the theta lower.

Another stupid comment I hear is that 90% of option expire worthless. I must say logic like that is pure ignorance. (1) any 400% OTM option may or may not trade, consequently how do you even run stats on an infinite number? Secondly,  if margin calls made one bankrupt 30 days before expiration (like MF global, LTCM etal), well expiration did not matter now did it?

Bottom Line: many think they are playing in the kiddy pool when they are actually swimming with a bag of meat on their back offshore Africa in shark infested waters.

Best of luck unbiased trading,

Volar


About The Author
Mole
Mole created Evil Speculator amidst the chaos of the financial crisis in early August of 2008. His vision for Evil Speculator is a refuge of reason, hands-on trading knowledge, and inspiration for traders of all ages and stripes. You can follow him and his nefarious schemes at various social media waterholes below.
  • Schwerepunkt

    Holy shit!  TOOMUCHMATHS. I got a headache now.

  • Anonymous

    Well, it’s back to “my old school” for me

  • volar

    i get a headache every time i code options

  • Anonymous
  • Anonymous

    what is TOS?
     

  • Anonymous

    If I understood this correctly, the message is “stay away”!  If you don’t understand that piece, never trade in options for more than a few hours or days scalping (at best) because you don’t truly understand what you are doing.  I understood only a very little of that, but came away with a pretty deep sense of what I don’t know!

  • volar

    thinkorswim

  • volar

    understanding what you dont know is knowing something in itself.

    Yes- if you have a price direction plan/trade/idea use futures/stocks, dont use derivatives unless you full understand them (goes for ETFs, ETNs and options of course).

  • Anonymous

    Damn!

  • Schwerepunkt

    I guess this is another trend day in the opposite direction. 

  • Anonymous

    AAPL testing its 20-day SMA

  • http://practicalt.blogspot.com/ Darth_Gerb

    cough, sputter, Firehose, too much, can’t breath.
    that’s it, time to hang up the options for good.

  • http://practicalt.blogspot.com/ Darth_Gerb

    okay, back in the channel.
    see the rectangle on the left?  I don’t think Market will just roll over.
    http://i39.tinypic.com/16a7jo0.png

  • volar
  • http://practicalt.blogspot.com/ Darth_Gerb

    what is this filtered?  some kind of Ice cold beer marketing?

  • Anonymous
  • volar

     LOL u know I hat AH trading… so i use a time filter to show gaps. SPX index does not show gaps correctly

    So pit hours, EMINI

  • Schwerepunkt

    Might be a good long right here. I would think markets will try to recover with Ben on deck at 1pm. 

  • Anonymous

    Ew, getting ugly:)

    AAPL getting hammered! About FN time!

  • Anonymous

    PUlling AUssie shorts. waiting for 20 pip pullback.

  • Anonymous

    Newbie here.  Just got this alert:  
    NYSE TICK closed 74.92% below its zero mark.LOW probability of a Down Trend Day!Does this mean we should look to go long here?

  • Anonymous

     placing one at 1.0360 and will be taking half at 1.0320 Then setting at breakeven. So the one above is now at 1.0405

  • Anonymous

    “Down Trend Day”
    If anything, you should look to get short on either a touch of VWAP or the ZL zero mark. Ideally, we shouldn’t break either (or at least not go higher than +0.5 on ZL). If we do, it’s probably not a trend day and there’s no edge in trading that alert.

  • Anonymous

    Tested the 25-day SMA. If it doesn’t hold, we’ll visit 556.
    I just checked a retail retard board. People there are starting to panic, since most of them bot massively leveraged OTC derivatives betting on more upside. If we drop further, this should turn into a full-blown panic.

  • Kudos

    Volar, I love these posts. I know I need to let it sink in and revisit them to get the full value of them. I even printed it out to come back to. 

  • http://practicalt.blogspot.com/ Darth_Gerb

    I already forgot, in all the excitement yesterday.
    a Like for U.

  • http://twitter.com/angrybear168 jimmy

    no but possible of reversal look for support if u want to long

  • Anonymous

    Nice, currently sitting on OTM puts:)

  • Anonymous

    Boring tape.

  • Anonymous

    Here comes the zero

  • Anonymous

    If its not a trend day dont trade the alert. Also you should not be posting the alert here!

  • Anonymous

     Sorry mate.  New to the game

  • Anonymous

    The alert worked great yesterday if you traded it.

  • volar

     good deal- glad u enjoy them. When printed they also serve a duel purpose of toilet paper- but keep your wits in check too

  • Anonymous

    Great post indeed! I always had this feeling that TOS really lacked the ability to give me the full picture on those plays.
    One question: Are there any tools you would recommend for analysing options (except Excel) or did you implement your tools all by yourself?

  • http://pulse.yahoo.com/_IF7HINHIP5ITYT6TDHACMWJUXQ Huisok

    huh?  euro dumping!

  • Anonymous

    Great post Volar.  In college I took an ‘Options & Futures’ class as a senior finance major.  We started with @ 100 students in the class and by the end of the withdrawal period we were down to about 50.   By end of semester we had about 20 left in the class room.  If you paid attention in calculus and understood derivatives/functions it was easier to grasp the greeks, if not then it was, well, Greek to you.

    Think of an options value of those rubber men you give to your kids. And delta, gamma, theta, vega & rho each pulling and pushing on his arms, legs and head, constantly disfiguring him: Welcome to options trading!

  • Anonymous

    Have we satisfied the VIX buy signal?
     

  • Joe_Jones

    no wait until the end of the day

  • Anonymous

    Doesn’t look like that will happen, need a lower close today. 

  • Anonymous

    If a lower close on Monday, does that satisfy the VIX buy signal or does it need to be today?
     

  • volar

     I use excel code- very easy actually.

    if u email Mole he can give u my email and i could share some of the code.
     
    basic excel code can be found at

    (bottom of page) http://unicorn.us.com/trading/

    and here is more simple/better code if you take out the 365 and change to 248:http://www.optiontradingtips.com/pricing/free-spreadsheet.html

    to get IV smiles i had to blow $$ at CME. http://www.cmegroup.com/market-data/datamine-historical-data/endofday.html

    for smile data i have the code to regess the smile every day

    and excel code for fixed smile regession of IV data:

    if data horizontal: cntrl+Shft_ent {=linest(yyyy:yyyy,xxxx:xxx^{1;2})}

    if data vertical: cntrl+Shft_ent {=linest(yyyy:yyyy,xxxx:xxx^{1,2})}

    where X and implied x^2 = (1/sqrt(time/248))*(ln(k/s))… this is moneyness/timedecay
     
    and Y= IV/Avg IV

    also if you need time/holiday code i have that as well

  • http://pulse.yahoo.com/_IF7HINHIP5ITYT6TDHACMWJUXQ Huisok

    copper pretty weak today…..

  • Anonymous

    Im talking about sp

  • Joe_Jones

    needs to be today

  • Schwerepunkt

    Only chance for the signal is neckbeard. [u suppose he reads this blog? if so, he’ll talk up more QE]

  • Joe_Jones
  • Joe_Jones

    I doubt it. Big boys haven’t raped sheep enough on the down side to call for more QE.

  • Kudos

    CB’s need to alternate with their QE. Its the ECB that needs to commit to a few more LTROs, not the fed.

  • Joe_Jones

    Wow Volar this is a bookmark for those trading options. 

  • Anonymous
  • Anonymous

    Took /ES short at VWAP:)

    Beard up shortly!

  • Joe_Jones

    I haven’t touched my short from yesterday. Broke even today. Now looking for the actual coins.

  • Schwerepunkt

    U r probably right, but maybe he wants to rape the bears again? hedge funds have underperformed the market, meaning they’re short. plus, he probably wants markets higher before Israel goes nuts. BOOM

    [and besides, he doesn’t actually have to DO anything, just wink, nod and hint and fart]

  • Anonymous

    2.5 hrs of SPX coiling around the 50dma (1375.96) should make this VWAP action interesting and telling for rest of day. 

  • Anonymous

    Action to start shortly!

  • Anonymous

    Thank you very much, mate. 
    I’ll look into this, though it’s probably too complex if you don’t trade sufficient size to justify the time you put into it (too small ROI).

  • Schwerepunkt

    Hey! I resemble that remark.

  • http://twitter.com/angrybear168 jimmy

    market going to sky rocket imo

  • Joe_Jones

    From what I read hedge funds are all-in long risk,… and scared to death too.

    Remember it’s election year. Obama wants a strong dollar and low gas prices. 

  • Schwerepunkt

    Then something’s got to give; strong dollar=lower gasoline, but also weak stock market. Which is more important politically? Probably gasoline. Maybe this entire 30% rally was engineered so it could be taken down for this summer silly season and driving season?

  • Anonymous

    My guess is that we’re going to make a new intraday low based on the absence of a ZL div. So far, we’ve stayed in the downtrend day playbook. Hourly, however, is showing none to the upside either, so another high afterwards seems likely.

  • Anonymous

    I really wish you would wait sometimes like yesterday.

  • http://twitter.com/angrybear168 jimmy

    market wants to go

  • Anonymous

    A tanking stock market, on the other hand, would result in vaporising retirements, media panic, failing banks and more bailouts or total financial collapse. High oil prices may actually be the lesser evil.

  • http://practicalt.blogspot.com/ Darth_Gerb

    trade the tape.
    trade the tape.
    trade the tape.

    prognostications based on gut are frowned on.
    😉

  • Anonymous

    Uncle Bennie will be pumping the dollar.

  • Anonymous

    high oil=credit deflation…prices are here to stay and the market will tank regardless…good read on what is happening energy-debt wise

    http://www.economic-undertow.com/2012/03/19/being-greek/ 

  • Anonymous

    http://content.screencast.com/users/AMCabrera/folders/Jing/media/c10baaf7-fece-4847-b995-cae842b6dbd9/2012-04-13_1319.png
     this is not bullish in short-term. Failure to capture 1380 AND was not ever close to threatening 1390.

  • Anonymous

     :-)

  • Anonymous
  • Joe_Jones

    most Obama voters don’t trade. If I were POTUS I would crash the market, make crude prices drop and bucky surge, and give a hard time to banksters. When the sheeple would beg for a bail out, I would then save the day with QE3, and probably bomb Syria and Iran as frosting on the cake to get right wing voters on my side just before election.

  • http://twitter.com/angrybear168 jimmy

    tape showing signs

  • Schwerepunkt

    Is your name Dick Morris? LOL

  • http://twitter.com/angrybear168 jimmy

    vwap conquered

  • Joe_Jones

    It’s a work in progress

  • simon n

    anyone know how to Chart VWAP indicator with traderworkstation for Interactive Brokers? Doesn’t seem like its on there in the charting tools

  • Joe_Jones

    LMAO! no, I don’t have Dick in my name.

  • Anonymous

    I know it can be frustrating to be a sane person and trade “equities”. That is why I rarely trade equities. Forex baby forex.

  • Schwerepunkt

    AUD.USD? What do you think? Bear flag, or bottoming?

  • Joe_Jones

    insane…
    😉

  • http://twitter.com/angrybear168 jimmy

    bottoming for today at least

  • Anonymous

    http://content.screencast.com/users/AMCabrera/folders/Jing/media/63b61cc4-e6ea-41fa-a44f-1babdc73cf81/2012-04-13_1354.png
    http://content.screencast.com/users/AMCabrera/folders/Jing/media/f3dc7ffa-9f78-4a27-8c10-5a6fb1b13182/2012-04-13_1355.png
    Bottoming? I have to say no. What time frame though? Because short term like hourly thirty minutes maybe. You know me I see a sucker play here for 1.0320 at least in hourly chart.

  • Joe_Jones

    Hmmm, VWAP break out looks like a fake out.

  • Anonymous

    btw quick test is failing as I type.

  • Schwerepunkt

    No, it’s not. Which is weird cuz using IB as my data feed, i can generate VWAP with Quotetracker. But, I learned recently that QT is being wound down. 

  • Joe_Jones

    risk off

  • Schwerepunkt

    So cheesy.

  • Anonymous

    VWAP breakout is a fakeout. I probably won’t be taking the intraday long scalp I was looking for now. Perhaps a good setup EOD for a Monday scalp will present itself.

  • volar
  • Joe_Jones
  • Anonymous
  • volar

     dude i printed that off sooo fast lol

  • Anonymous

    Zero is not doing much leading of the tape today – no significant divergences, no significantly strong signals, no trend day.  Sometimes, that’s just the way it is.  No edge, no trade.  It’s up to you…the most I see is a potentially rejected VWAP test here, but the zero reaction hasn’t been much more than to follow the tape so I don’t see zero as giving us much here (lack of a trend day also influences that).  Agree with Darth alias G. Gerb:  gut prognostications are frowned upon (also self-correcting as your account will not long survive!).  

  • Anonymous

    Cotton looks interesting long term. It has a weekly and monthly RTV Buy setup. Also, Gold with a weekly fakeout buy.

  • Anonymous

    Damn good read. Thank you!

  • Anonymous

    Artemis produces some good stuff and this was no exception. Keeping this one on my desktop for future reference.

  • nyse

    Sick post.

  • Anonymous

    Thanks. I think I learned a little more about Volar’s post too.

  • Joe_Jones

    Wow!!! This is amazing! Thanks for the link.

  • nyse

    thanks