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Volatility Skew

'Volatility skew' is one of those topics that many traders ignore.  It's not something that was understood in the early days (1973 +), when options began trading on an exchange.

According to Wikipedia (quoting John C Hull): "equity options traded in American markets did not show a volatility smile before the crash of 1987, but began showing one afterward."

A volatility smile is defined as 'a long-observed pattern in which ATM options tend to have lower IV (implied volatility) than in- or out-of-the-money options. The pattern displays different characteristics for different markets and results from the probability of extreme moves'

Volatility_smile

image courtesy of investorglossary.com

 

In other words, black swan events occur more often than predicted by mathematical models, and far OTM options trade with a higher implied volatility than ATM options. 

In today's world, this volatility smile is so skewed to the downside that the IV of OTM puts is significantly higher than that of ATM options, which in turn have higher IV than OTM calls.  This is considered as rational in light of the 'frequent' market crashes.  Frequent is defined as far more often than any mathematical model would have predicted.

 

Kurtosis is the mathematical term used to recognize that not all tails of the curve are created eual and that market crashes are far more common than market surges.  Thus, PUT IV exceeds call IV.

The early texts could not mention 'volatility skew' and many of us 'grew up' in the options business with no understanding of the importance of volatility skew.  I now shudder to recall that one of my favorite strategies (late 70s and early 80s) was to own ratio spreads in which I would buy one put with a higher delta and sell 2 or 3 times as many puts with a lower delta.  I thought I was capturing theoretical edge by selling puts with a higher implied volatility.  Today, if anyone were to use that ratio strategy, it would not be to capture edge.  It would be more of a bet on where the market is headed next.

Volatility skew is easy to notice.  All one has to do is look at IV data for any option chain.  Nevertheless, the concept has often proven difficult to explain.  Saving me the trouble of attempting to do just that, Tyler Craig at Tyler's Trading recently described volatility skew in a nutshell.  Thanks Tyler.

 

When teaching traders who have not yet discovered the importance of volatility skew, the skew can be used to explain why one specific strategy is more profitable under certain market condition that others.  This is an important topic for future discussion. 

Mark Sebastian at Optionpit.com suggests one good method for following the volatility skew for a specific underlying asset.  It takes a bit of work, but owning a good picture of skew, as it changes over time, is probably worth the small amount of time that it takes to track the data. 

Sebastian also makes the important point that it's not a good idea to constantly trade the same strategy, using the same underlying, month after month (Guilty.  I'm a RUT iron condor trader.)  Instead volatility skew, among other factors, should be considered.  Iron condors work well when skew is steep and less well when skew is flatter.

Obviously this discussion is incomplete, but just knowing that volatility skew exists and that it can help a trader get better results, makes it a topic that we should all want to understand.

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Lessons of a Lifetime: My 33 Years as an Option Trader

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Trading Iron Condors for a Living

Hi Mark,


I'm Roberto from Italy, sorry for my bad English.


I want to thank you for the professional advice that you give to us.  It's very useful; I bought your "lessons of a lifetime" and it's very
useful too, thanks again.


I know options trading since 2006, but I made very few trades in the
real market, losing a couple of hundreds of $. I take a break from the
real market and go back to study, and I realize that I always need to
study!


My question is: in your opinion it's possible to live by trading? Do you
live by trading? Do you know someone who lives by selling iron condors?
And last but not least, do you know some hedge fund that operate in
options, especially iron condors?

Many thanks from Italy.

I follow you every day.

Roberto

***

Buona giornata, Roberto

Thanks for reading the blog, and there is nothing wrong with your English.  Yes, the education process, or the need to study, is something that does not end.  Just think about how professional athletes – Tiger Woods for example – always practice. 

Yes, it is possible to live by trading.  But, it is difficult.  The very first truth is that you must prove to yourself that you are a profitable trader – consistently – before you give up your job and try to trade for a living.

Here is the part that most people fail to recognize:  Novice investors believe they can quickly easily to make enough money to support themselves and their family.  Why would someone believe that to be true?  If you want to determine if you can do it, then you must first make money by practice trading.  That means  using a 'pretend' account, or paper-trading.  If you are successful, and ONLY if you are consistently successful – then is the time to think about trying to trade for a living.

If you cannot make money in this account, there is no reason to believe you can do better with real money.

Next consider your bankroll.  How much can you place in your account and still have enough to meet your daily needs – just in case you don't make any money right away?  Next consider your rate of return.  If you can earn 20% per year, consistently, then you would be a very successful trader.  Some people do far better.  Most do not.

Putting all that together, if you have $100,000 to invest and if you earn 20% per year, can you live on $20,000?  Probably not.  And don't count on earning that 20%.   It's not available to most traders.

You tell me.  Can you make a living as a trader?  Are you willing to devote the time to practice?  Do you have enough cash?  Are you alone, or do you have a family to consider?

If you can meet those difficult barriers to entry, I guarantee that the number one factor that will determine your success (or failure) as a professional trader is your ability to manage risk.  That means you must trade without emotion.  All decisions must be ruled by logic.  You cannot get greedy and you must act decisively when your positions get into trouble. On the other hand, you cannot just take a loss every time the market makes a small move.  Can you do that? Can you handle the pressure?  Practice and find out.

Get started

Practice trading.  Do not use real money.  Open a few different iron condors at one time and manage them.  Take this process seriously – do not look at this as 'only' play  money.  To you, it must seem to be real money.  Succeed at that – and you have a chance. 

Roberto – you may be able to do this.  But not everyone can.  That's why you must know how good you are before making the commitment.  You do not have to be the best.  You just have to be good enough to make enough to meet your needs.


Your questions

I do not live by trading alone.  My positions are not large enough to earn enough cash, unless I get very lucky.  And that's fine.  I am at the stage where I cannot afford the risk. 

Many people claim to live by trading iron condors, but I do not personally know anyone who does that.

There are hedge funds that trade iron condors.  I don't know the names of any.   I suggest that you do NOT pay someone to trade iron condors for you.  That includes hedge funds.  They take 20% of the profits, plus  more in fees, and there is not nearly enough profit left for you.  Most hedge funds require that investors be wealthy before accepting them as clients.

I just published a page that discusses the topic of getting started as a trader.  You may find it helpful.

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Lessons of a Lifetime:  My 33 Years as an Option Trader,


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Stock Options: White Hats or Black?

Remember early TV days when the 'good guys' wore white hats and the 'bad guys' wore black?  It was easy to tell them apart.  Today, the white hats of the investment world are seen as wearing black hats by far too many.  Options.  Those are the good guys.

White hats

This post was first published at The Options Zone.

The word
‘options’ evokes a negative emotional response from people who never use them,
don’t understand how they work, and who prefer to remain in the dark.  Many investors truly believe that options are
risky investment tools, used only by high-rollers.  Thus, they make no effort to see ‘what all the
fuss is about.’  Surely they know that
huge numbers (several billion per year) of options trade, but they have no
curiosity.  Why?   I’d guess that an uneducated broker once
told them that options are ‘dangerous’ and are too complicated for the
individual investor to understand.  The
truth is that those stockbrokers were unwilling to learn, and provided a
disservice to their clients.

Today, the
world is more efficient, with useful information (along with misinformation and
hype, so please be careful) all over the Internet.  Options Zone is a safe place to learn about
options, and that’s the reason I accepted an invitation to participate.


Those of
us who understand how options work reap the benefits.  Those who prefer ignorance, must trade with
much more risk than necessary.  For most
investors, bull markets provide profits and bear markets bring the realization
that investing is not a gimmie.
Options are unique.   

The
first obvious difference between options and other investments is their limited
lifetime.  However, the most important
feature of options – the one that makes it an indispensable investment tool –
is that options allow an investor/trader to measure and manage risk. 

  • If you choose not to be hurt during a bear
    market, you can own insurance against large losses
  • If you prefer to use leverage, you can attempt
    to turn a small investment into many times that amount.  This is the ‘gambling’ aspect of options
    that I don’t recommend – but it’s your money and you make the decisions
  • You can own an option position that benefits
    when specific stocks, or indexes, trade in a narrow range.  Or you can own a different position that
    earns money when a specific stock moves much higher or lower
  • Whatever your outlook for the market – bullish,
    bearish, neutral – there is a hedged options trade that earns a profit if
    your outlook becomes reality.  NOTE:  This sentence is not what the hypesters say.  Their line is 'you an make money in any market.'  Sure, but you have to be correct in your forecast.  You cannot take a bullish stance and expect to profit when the market crashes
  • The bottom line is that each of these objectives
    can be attained with limited risk.  There’s
    no need to invest large sums to buy stock. 
    Options can be used to meet the needs of anyone who trades stock,
    commodities etc.

When you
own options, the passage of time is your enemy. 
But you can earn a profit when your prediction comes true.  By hedging the trade and accepting a limit on
profits, ‘time’ risk can be cut considerably. 
When selling options, you earn profits as time passes.  However, other risk factors make this idea
too risky for most investors. Again, by hedging and accepting a smaller limit
on possible profits, that risk can be cut dramatically.

My
purpose today is not to compare the advantages or disadvantages of adopting
various option strategies.  Instead it’s
to point out that you can measure, and reduce, the risk of investing.  That’s why options are special and worth the
time to understand how they work.

More
experienced option traders know better than to try to make money by constantly
buying or selling options and predicting how the market will move.  They understand how difficult it is for the
vast majority to have an inkling of what’s coming next in the stock markets of
the world.

These
investors trade spreads, or reduced-risk, hedged positions.  I’ve discussed the best features of
some basic spreads and explained how to benefit by adopting them (see 'categories' in the right-hand column).

Today,
the idea is to help option rookies understand that options are used to hedge
trades – on a continuing basis – to reduce risk.  Note: options are not perfect.  If you want the combination of zero risk and guaranteed
profits, you are living on the wrong planet.

One
example is the popular strategy: covered call writing.  Investors earn profits when the underlying
stock moves higher, holds steady, or declines by a small amount.  It’s very popular among new option traders,
but serious, experienced investors also use this method.  In fact, there are mutual funds dedicated to
writing covered calls.  The point to be
made is that this method comes with risk. 
If the market tumbles, covered call writers perform better than those
who simply buy and hold the same stocks. 
But, by using options judiciously, risk can be reduced even
further.  By varying the specific options
traded, the covered call writer can enhance the upside or gain additional
protection against a downside move. 
Options are versatile investment tools.

Option
strategies can be used to reduce risk and enhance the probability of earning a
profit.  The profits may be limited, but
the combination of more winning trades and smaller losses is appealing.  Only options can do that for an individual investor.

660

Lessons_Cover_final Are you a fan of Options for Rookies?  Have you benefited by reading
this blog?  Are you one of the many readers who has sent congratulations
and thank you messages for proving valuable content? 

I thank you for the kind words of encouragement.

 


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Position Size: When Is it Safe to Increase?

Mark,

You
bring up an interesting point about increasing position size. You
mention increasing to two kites with a max of 20-lot of iron condors. But assume
that you don't use kites to protect against excessive moves, and
prefer covering part of the position to reduce risk.

By how much of an
increment would you recommend increasing your position size if you're
used to trading 10 lots? And once you've become comfortable with the new
size, how frequently would you consider increasing size again and by
how much? This assumes limited capital constraints — within reason of
course.


Thanks,

Burt

***

Owning insurance allows a minor size adjustment.  But it's minor.  Insurance does not guarantee that you will not incur losses.  If you trade without insurance – as most do – size increase can only occur when it is justified.

My basic philosophy of trading is involved with this answer.  There's more of that philosophy in Lessons of a Lifetime.  I caution you to find a trading philosophy that suits you, and not blindly follow my suggestions.  The reply below is based on my comfort zone and experience.

1) Do not increase position size until you believe you understand how to manage risk for the strategy (or strategies) being traded.

2) Be certain that you get the nuances of the strategy and that you are comfortable with your positions and confident that you can earn money using these methods.

3) As a side issue:  Most people who trade have no idea that the average result for people who try to become short-term traders is to lose money.  That's the average result.  Most never become profitable.

I don't know how true that statistic is for us.  As option spreaders, we hold positions longer than the short-term trader.  Our success does not come from reading short-term trends.  It comes from managing risk efficiently and adopting methods that are appropriate for our psychological needs.   I suspect than earning any reasonable profit represents an above average result.

4) Before you even think about increasing size, you must be profitable.  Comfortably profitable.  Only you can determine what that means, but it does not mean earning $50 per month, after expenses. You must be able to see your account value increasing.  If you are withdrawing money for living expenses, then it's especially important not to increase size and jeopardize a significant portion of your account.

Although it may not be easy to determine, I'd want to know that profit did not result only from good luck, but instead was based on action taken or decisions made.

5) You must have faced several risk management decisions and handled them effectively.  If it all went smoothly and you had no pressure and no tough decisions, you have no method for measuring your skills.  I know that a string of profits is encouraging, but it is not enough to begin trading larger size.

What's a good decision?  It's not that the 'adjustment' made lots of money. It is knowing that the decision accomplished your risk management objectives:  it reduced risk, it resulted in your owning a position that met your needs and fit within your comfort zone.  It means you did not take defensive action just to do something.  It means that you wanted to own the newly adjusted positions and did not own it because it was 'the best' you could do. Furthermore, it means that additional handling of the position was done carefully and intelligently.

6) If you pass those tests, next comes your comfort zone.  Try a 20% increase and trade 12 iron condors, and remain at that level for several months.  When you believe you are ready to move to larger size again, repeat the entire process. 

Carefully examine what has been happening.  Do not rely on 'profits' as the sole factor that determines how well you are progressing.  Examine the same questions you tackled earlier.  If you do not find proof that you are handling the positions skillfully, do not increase size.

Yes, that advice is easy to ignore when you are making money.  But if you cannot prove to yourself that you have been skillful, rather than lucky, trading larger size will make things more difficult.

7)  Here's the problem:  If the market is kind to iron condor traders – as it is part of the time – you can get lulled into a false sense of confidence and when it hits the fan, you may have too much size to handle comfortably.   It's really easy to lose a year's worth of gains in a hurry – especially when trading too much size.

8) Don't ignore the size of your account.  I note that your question does take this into consideration.  But overconfidence can bring big trouble.

If your account value is not growing steadily, then it's too soon to increase size. No matter how much you decide to risk on a specific trade, it must never be large enough to jeopardize your being able to stay in business – if something terrible happens.  And it will happen – if you trade long enough.  You can own insurance to offset the major part of the problem, but that's not a cheap fix.

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Believe it: You Always Have Something to Learn

Thanks to a heads-up from Tadas at Abnormal Returns, I found a post with such good advice that I had to pass it along.  This is one of those situations in which I recognize my own failings.   Had I paid more attention to this idea, I know it would have made a huge difference.  I'm passing it along with the hope that readers take this seriously.

David V, at CSS Analytics, subtitles his blog: Use Quantitative Research to Beat the Market. Under normal circumstances, I'd look at that title and move on because I believe it so difficult for anyone to consistently beat the market.

But this post is special to me because it focuses on education.  It also reminds me that I failed to do that hard work, that I failed to strive for greatness and that I took the easy road.  Not everyone has the drive or skills to rise to the top.  But if are talented and diligent, believe these ideas, and truly work at continuing to learn – throughout your lifetime – then the potential rewards are available to you.  If you take the lazy approach, you may do well or you may fail miserably. 

David's path is not easy, but do the rewards justify the effort?  That's your personal decision.  But I know that it's worth your time to read the entire post, but here are some excerpts:

The intelligent person will start out in any given field–whether music,
athletics or academics–as a student of those who are more experienced or
talented. Through the course of “10,000 hours of practice” and a lot of
guided learning, these same students will likely emerge as “experts” in
their field (assuming they have enough talent).

The reality is that they have to always try to improve to avoid
falling behind.

The same thing applies to trading. Big money managers compete against
other money managers, traders compete against other traders. Just when
you think you are good, look out because someone better than you is just
around the corner. You have to always work hard, and try to be one step
ahead–otherwise my friend you are going to fall behind.

Michael Jordan was Michael Jordan because of all of that–and no one ever
hears or talks about the more talented players that never made it
because they were lazy.

For this reason, you are never an expert. No matter how good you are, or
how good other people say you are, it really doesn’t matter. Always
think of yourself as a student–someone who always has something to
learn. You must absorb as much as you can from other experts, and even
question their root assumptions.  Once you become the expert, you have
to learn to question your own root assumptions–because the only people
you speak  to most often are looking for answers.
Those who
never question will not only never find the answers, but they will also
fail to truly understand how things work. This framework has been the
foundation for all scientific progress.

People with lesser knowledge and skills can easily surpass you through
sheer discipline and constant work ethic. You need to know what to do,
and you need to actually do it for”10,000 hours” to really absorb the
knowledge you have accumulated. If you haven’t done or are unwilling to
do that then as a trader you are going to have to mechanize your
trading–because no matter how much you know about the markets, you still
have to know how to manage yourself just as much to succeed.

It's never too late.

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My 33 years as an options Trader.  In Lessons of Lifetime, I share some of the ideas I've learned through the years, including my philosophy of trading and how I look at trading, positions, risk management, record keeping etc.

The ebook will be launching within one week, as I'm still in the editing phase.

Lessons of a Lifetime: My 33 Years as an Options Trader is approximately 18,000 words in which I share some of the ideas I've learned through the
years.  that includes my trading philosophy and how I look at trading,
positions, risk management, record keeping etc.

Note:  eBook only; no hard copy available.

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Price: $12.

Order now – before the official launch date, and pay only $10.

I'll notify you when book is ready for download.

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VIX Graph March 13, 2010

There's not much to say about VIX from my perspective.

The market marches higher, and VIX has been going nowhere.  What is not obvious from the data is the VIX is significantly higher than the realized volatility of the market.  We have not only been heading higher, but the average daily moves are much smaller than in recent memory.

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Lessons of a Lifetime: My 33 Years as an Options Trader by Mark D Wolfinger

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