|
PureBytes Links
Trading Reference Links
|
Gitanshu:
Thanks for your reply. Here are my comments on your comments (so to speak).
1. If sigma = "std deviation", I would think that 4 deviations is like a
0.002% chance of occurence?
* Based on a normal distribnbution of returns, you would expect so. However, peters' research suggests that returns are not distributed normally and therefore the "tail flick" at 4 sigmas represents a higher probability.
In any distro, the event is recorded only upon occurence - after the fact.
a. Even if a 4 sigma event happens, the probability of 2 consecutive 4-sigma
events happening back to back is practically non-existent?
b. One would still need to watch this "tail" and probably be better off not
trading the option market in a tail event unless one is
- extensively capitalized,
- has an accurate directional or volatility bias,
- and guts of steel
c. If one does have an accurate directional assessment and still wants to
trade a tail event, trading the underlying has a better risk/reward
profile - because at these tail events, especially in the major indices and
equities,
either
- the rules of the game get changed (increased margin, lesser supply,
lack of liquidity at desired prices, fast market conditions upsetting your
balance)
or
- the premium erodes faster than directional bias benefit.
Case in point: Oct 28, 1997 - SnP, Intel, IBM options v/s underlyings.
* I agree entirely. In fact I shudder when I read "options experts" proposing short strangle positions to novice traders. I was taken in as a novice. I had Paul Forchione (who came up in the discussions last week) manage an account for me. He insisted on putting on what Opportunities in Options call "Neutral Options Positions", which are basically short naked strangles, in this case in the bonds. After about 4 months and 33% drawdown, I stopped Mr. Forchione out. OUCH!
Even worse, I saw Don Fishback's "Options for Beginners" book advertised all over Investor's Business Daily in recent weeks. His basic "ODDS" method is selling calls and puts at 5% above and below the underlying with one mointh to expiration. In today's S&Ps, 5% represents around 55 points. If the market trends it would need a sustained move of just over 2 points per day to hit Mr. Fishback's short options (and imagine the drawdown pain before expiration!). I haven't done the historical backtesting but his claim of profitability in over 90% of cases seems highly dubious and potentially disastrous for options beginners.
>Therefore, consistently applying the following spreads over a long enough
period of time should prove profitable
>
> long a call at 1 std dev above the underlying and short a call at 2
> std devs above the underlying
>
> long a put at 1 std dev above the underlying and short a put at 2
> std devs below the underlying
Yes, works ONLY if reversal takes place at the 2 sigma levels.
* Or rather, it works if the market makes moves above 1 sigma, since the price of aoption 1 sigma out of the money will be tied to its probability of occurance based on a noirmnal ditribution of returns. Since returns are not normal, Peters has shoewn the price of options 1 sigma above the underlying to be UNDERPRICED. Therefore consistently buying at this level should return dividends in the long run.
However,
there are many times when 2, even 3 consecutive 2-sigma moves happen in the
same direction, chewing up your trade - because it has a directional bias.
This is where delta-neutral trading (or volatility trading) becomes
relevant - you're playing volatility expansion/contraction, not direction.
* Why would consecutive 2 sigma events "chew up the trade"? The idea propounded was to be simultaneously long an out of the money bull spread and an in the money bear spread, makingthe position more of a volatility trade than a directional trade.
>Now of course the fly in the ointment is that implied volaility nearly
always differs from historical volatility. Which leads to the question:
does it increase the odds even higher to go long a 1 std dev above and short
at 2 std devs above if ...
>
> implied volatlity is below historical at 1 std dev above
>
> implied volatility is above historical at 2 std devs above
>
> both of the above.
I experience the following:
If IVol is significantly below HVol, prices are glued around its mean, and a
half-sigma event is in progress. Since even a half-sigma event is not normal
behavior, prices should move back to a one or 2 sigma level.
* Volatility is mean reverting. Under the normal distribution hypothesis, the mean would fall at ZERO volatility (i.e., no price movement). Under the fractal analysis, the mean actually occurs between 0.5 and 0.75 sigmas above the underlying (for the DJIA at least)! Therefore, prices at a 2 sigma levle should be epected to revert back to a +0.5 to + 0.75 level.
Direction is
difficult to predict using only volty readings, one needs technical analysis
to work this out. However, this is where volatility expansion is definite
because volatility is mean reverting - whichever volty you're looking at -
IVol, HVol. Thus a volatility trade is good since a small move in the
underlying will cause a disproportionately large move in the option premium.
* No question.
If IVol is significantly above HVol, prices are already recording a 2-3
sigma event. As explained above, a directional bias is useless if trading
options, because a greater percentage move in the underlying is needed to
double the price of the option. Again, a volatility capture trade is
profitable, if the circumstances allow.
If Ivol is anywhere between these 2 zones, directional spreads work or even
naked bullish or bearish positions work. Volatility capture is difficult -
or pointless - coz at the market maker's side, whichever model is being used
to compute option price/volty (Monte Carlo/B-S/Coxx etc), the market maker's
spread between expected returns and the t-bill/dividend yield spread are
narrow - so they are neutral to direction already, and by consequence option
holders tend to benefit or lose almost proportionately with the underlying's
performance.
* Two points: I think you need to shift your concept of "mean volatility" upwards from 0 sigmas to 0.5 - 0.75 sigmas as mentioned above. Also, the notion of "consistency over time" is very important.n Over time the market maker will not have the advantage if (s)he is basing the price of the options that (s)he trades with you on the Black Scholes model (since B-S calculates price based on the assumption of normaility).
This is why the general "trusim" probably emerges - trade only at-the-money
or in-the-money options - coz these have delta of 0.5 or better, which
dampens your portfolio's volatility.
* But again, delta is only valied if you accept a gaussian view of market volatility.
Gitanshu. It's all fascinating stuff. I'm anxious to here more.
Cheers,
- Stuart
|