Archive for November 2010

Options: Learning About Volatility   Leave a comment


In October, I was watching the QQQQ climbing for several days. I wasn’t willing to bet that it would continue to rise, but I was willing to bet that it would change and I had a hunch that it might also move more than normal due to the elections coming up. I decided to open a long straddle.

Here’s a chart now (November 8th):

Effectively, instead of betting on the value of the underlying changing, this position is betting that the QQQQ will change more than it has recently. Antithetically, each day that ticks by has a cost that diminishes the value of the contracts. Hopefully, an uptick in the volatility of the QQQQ will offset the time decay of the long contracts, right?

Considering loss control was my first concern. My loss tolerance on this trade was 25%. Using January $52 contracts and an end-date of November 19th insures that I will not exceed a 25% loss. (I did not fill in the numbers for targets, so ignore the last 3 lines in the graphic)

 

The $52 call was selling for $2.22. The greeks are recreated below. Note the volatility of the call – At the time, this didn’t really seem elevated compared to the QQQQ’s roughly 18% volatility. I would have been much better off if it was below the historical volatility of the QQQQ, but the likelihood of that happening is pretty slim.

Today, the IV of the calls is 22.28% and QQQQ’s historic volatility sits at 22.26%. The small bid/ask spread also makes the QQQQ good for trading.

The price of the underlying has not moved enough to get into the green on this trade. At this point, while I was right in guessing that the volatility of the QQQQ would rise, it has not risen nearly enough to offset the cost of time in the contracts. As time passes, that decay will accelerate.

Here is the profit/loss graph of the position at expiry. The red line marks its position today.

I’ll probably close the trade this week and limit the loss. However, in the interest of improving my strategies when trying to use volatility, I’ve started to read The Volatility Edge in Options Trading by Jeff Augen.

To date, I haven’t done much with trades based solely on volatility but I am definitely interested. Clearly, a sharp increase in volatility could have created a nice profit on this trade. For example, if volatility doubled to 36%, the position would yield about a 50% gain at today’s closing price. With such a big election “event”, I expected a little more movement in the market.

Hope you enjoyed the article.

(All of the images above were taken from OptionsOracle, Fidelity Active Trader Pro and OpenOffice.org Calc)

Posted November 8, 2010 by jeffkeith in Investing, Options

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