Ceteris Paribus

I haven’t done these for a while – so it’s once again time to do a post on the basics of eeking out a living as an option slinger. For the traps are many and it’s easy to get bitten in the ass if you don’t know what you’re doing. Today’s VIX chart may aid in elucidating my point:

First it’s obvious that those two converging MAs pose significant resistance – given that even a possible future AAA downgrade of the United States credit rating can’t push this thing above 20.

What’s even more interesting from a trading perspective is the near 7% drop on the VIX – which if you went long any options yesterday would have made a mark today. That’s right – vega (i.e. option volatility) is a cruel mistress and whether you’re right or wrong on picking a direction, she may still grab your wallet and kick you in the nuts.

If you’re a noob you may be scratching your head right now, so here’s a passage from a well written piece over on investopedia:

Vega, just like the other “Greeks” (Delta, Theta, Rho, Gamma) tells us about the risk from the perspective of volatility. Traders refer to options positions as either “long” volatility or “short” volatility (of course it is possible to be “flat” volatility as well). The terms long and short here refer to the same relationship pattern when speaking of being long or short a stock or an option. That is, if volatility rises and you are short volatility, you will experience losses, ceteris paribus (i.e. other things remaining the same), and if volatility falls, you will have immediate unrealized gains. Likewise, if you are long volatility when implied volatility rises, you will experience unrealized gains, while if it falls, losses will be the result (again, ceteris paribus).

Volatility works its way through every strategy. Implied volatility and historical volatility can gyrate significantly and quickly, and can move above or below an average or “normal” level, and then eventually revert to the mean.

Let’s take some examples to make this more concrete. Beginning with simply buying calls and puts, the Vega dimension can be illuminated. The table below provides a summary of the Vega sign (negative for short volatility and positive for long volatility) for all outright options positions and many complex strategies.

–	Vega Sign	Rise in IV	Fall in IV
Long call	Positive	Gain	Lose
Short call	Negative	Lose	Gain
Long put	Positive	Gain	Lose
Short put	Negative	Lose	Gain

The long call and the long put have positive Vega (are long volatility) and the short call and short put positions have a negative Vega (are short volatility). To understand why this is, recall that volatility is an input into the pricing model – the higher the volatility, the greater the price because the probability of the stock moving greater distances in the life of the option increases and with it the probability of success for the buyer. This results in option prices gaining in value to incorporate the new risk-reward. Think of the seller of the option  – he or she would want to charge more if the seller’s risk increased with the rise in volatility (likelihood of larger price moves in the future).

Okay, the simple translation of this is that you don’t want to be long vega right after a spike in volatility as we saw yesterday morning. In most (but not all) cases it is reasonable to assume that volatility will soon reverse toward the mean. And the translation of that is that you will get your ass handed to you if you buy long options after some unexpected sigma event.

But of course there are also opportunities here as well. No, I am not going to tell you to start writing puts or calls as that’s a guaranteed way to blow up your account if you don’t know what you are doing. But the real fun of playing vega is of really toward the short and even sideways side.

Lets forget about prices for a second and just assume that the VIX may actually drop toward 13 or 12 – perhaps conveniently timed as those two Bollinger bands start swinging up. Now that would be a spot I would want to be long vega and at that point it would not matter if prices actually follow through – assuming you don’t run out of theta (another greek affected by time) a sudden rise in volatility would do wonders for your option premiums – no matter if you are short or long.

My point of this post is simple: Don’t always just focus on price. Sometimes there are opportunities to bank coin that may not be immediately apparent. Knowledge is power – and in the end that may lead into banking coin.

Cheers,

Mole