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Stan:
You make some excellent points. Let me try to respond:
Using implied volatility to create a projection of the market's range is equated to sigma by Anand based on the notion that if historical volatility were being used, the figure would indeed be one standard deviation of the variance around the mean. In this instance you would expect the market to stay within the 1 sigma bounds 66% of the time (an assumption based on gaussian marthematics. Edgar Peters' with his fractal theory of the markets would argue otherwise, but let's not go there.)
Anand's point is that if you use Implied Volatility rather than historical volatility to create a range projection, the market will trade within this range 90% of the time. Basically, options traders are a more reliable barometer than past price history.
Therefore, the logic goes, you can sell options at 1 sigma (USING IV TO CALCULATE THE SIGMA NUMBER) and have a 90% chance of seeing those options expire worthless.
Now, as several people have pointed out, the other 10% will kill you. But no one says that to go short an option has to be a naked sell.
Anand proposes backspreads where the short options are on the 1 sigma bounds.
He also proposes short naked strangles with the options sold on the 1 sigma bound in markets where you are expecting calm. This sounds dodgy indeed to me.
However, I am considering the following 2 strategies:
1. In times where Implied Volatility is low by historical standards (like now for example), buy a straddle. If the market sits still or continues to move up slowly, this position will get hurt, and should be taken off early. However, if as the E-Wavers suggest, the markets tops out, a decline in the S&Ps will send IV up hopefully enough to counter time decay, and price movement will send one half of the straddle into the money.
2. Assuming the e-wavers to be correct, sell extra naked calls at 1 sigma out of the money (again sigma is here based on Implied Volatility, not Historical Volatility). This position should work because:
- it is only threatened by upward price movement. However, even upward movement is countered by a decreasing IV (in the S&Ps at least, IV decreases as price moves up) and time decay.
- you can track a 1 sigma move on a day-to-day basis. Thus, after 2 days you would expect the market to have moved a maximum of X points, after 5 days, Y points, etc. If the actual figures exceed those sigma-based expectations by too much, you know the market is marching to a different drummer and it's time to get out while the losses are still manageable.
I hadn't thought about projecting the market based on farther out futures prices. This is an intriguing thought, and I suspect there's a whole school of thinking devoted to it. If anyone has any insights I'd love to hear them.
- Stuart
>>> "Stan Rubenstein" <stansan@xxxxxxx> 07/20 3:13 PM >>>
Stuart,
I have seen the Doctor's opinion and I have another, criticism that makes
the Anand theory not as easy as it seems.
The use of Implied Volatility to estimate the max range of the S&P500
or any equity for that matter is not necessarily a matter for historical
proof.
It is however a foundation for option theory.
But what is missing is the probability of reaching any of the prices in the
range
including the extremes.
The mathematics in your formula is option math to extract a daily
volatility
from the annualized IV of 15% and then apply it over the time period of
32 days to expiration. Straightforward stuff.
In a sense what Anand and the formula says is this:
Given a daily volatility on the S&P500 price where can it reach, at maximum
(+ or
-) over a 32 day period. But the probability of reaching the + maximum 1253
or
- maximum1147 is unstated and could be 1% or less.
Because you would have to hit an up volatility every day, in succession, to
reach the 1247.
Do you think that the S&P moves up every day at such a maximum daily
volatility?
I'll put it another way.
It's much more likely that each day the S&P500 alternates up and down by
the daily
volatlity and in that event could reach, at the end of the 32 days, the
same value it
started with. Think of it as + 1% followed by - 1% followed by +1 %
followed by - 1%
until the end of the 32 days period.
The 1 sigma reference from Anand in your ending paragraph attempts to deal
with
this situation. In Statistical Theory a 1 sigma is a 1 standard deviation
from the average
and has a 66% probability of achievement if the prices have a Normal
distributon.
This would have to be proven from the historical record.
However I don't recognize what you mean by "strategies that are SHORT...".
Does this mean that Anand advises going short when the S&P500 reaches +1
sigma or
- 1 sigma price levels?
I replied to the general RT list in the hope of eliciting others for
comments.
Your subject is a good one, Stu.
Regards,
Stan Rubenstein
P.S.
Amend your wording. The IV does not provide the real range for the market.
It
does provide the current projection for the range implied by the current
option price.
Since option prices are always changing, often significantly, the projected
range of the
S&P500 is similarly changed. Nothing "real" here just the expectations of
the option
traders.
Have you given thought to how the S^P500 Futures, 3 months or less out,
gives you
another view of the future level of the SPX?
----------
> From: Stuart Hazlewood <shazlewood@xxxxxxxxxx>
> To: RealTraders Discussion Group <realtraders@xxxxxxxxxxxxxx>
> Subject: Option Strategy
> Date: Monday, July 20, 1998 11:44 AM
>
> I just finished reading a book by someone called K. Anand containing some
rudimentary option strategies (backspreads, naked strangles, hedged with a
long straddle when IV falls, etc.)
>
> The news in it was the following: according to the author Implied
Volatility provides the real range for the market over any given time
period. Thus you take the at the money IV for let's say the S&P and
project the market range based on this number. For example, assume the
following:
>
> Sept S&P is @ 1200
> At the Money IV = 15%
> Days to expiration (August) = 32
>
> Expected movement = sqr root (32/365) * 1200 * .15 = 53
> Expected range at expiration = 1147 to 1253
>
> The real news is that, according to Anand, this range has held true
historically 90% of the time. He therefore recommends strategies that are
short at 1 sigma based on the at the money IV.
>
> Since I have not been able to find a database of at the money IV for the
S&P, I have not been able to back test the theory. Any comments?
>
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