Vega, measures the potential change in the price of an option relative to the change in implied volatility. If implied volatility is to rise 1%, Vega tells you how many dollars will your position appreciate... or depreciate. Because implied volatility may increase or decrease instantly, with one single piece of news or lack-thereof, beginners are encouraged to trade vertical spreads, condors and butterflies, because they neutralize Vega, allowing you to trade as you are used to: vertically or sideways. We understand a stock going up and down, but do we really need to understand Vega?
I often compare an option position as a chariot pulled by 4 horses: Delta, Theta, Gamma and Vega. I like to say that if one falters, the others pick up the slack. As most metaphors, this one is inexact, because the strongest horse of the 4 is Vega. Yet, we routinely seek to avoid it, when we should be looking for situations in which Vega is low and likely to rise. Just the same as we would buy a stock when it is low and likely to rise. I have found that Vega is most likely low and likely to rise among momentum stocks, preferably after earnings when good news tend to relief investors and thus cause them to lower their guard, sell the protective puts in order to get the maximum bang for the buck.
Only days ago, BIIB jumped after good earnings, as the stock had rallied with the entire biotech sector, which has been very hot as of late. So you could have entered a stock position with a mental stop. Let's say that you have about $125,000 in your trading account, although you can scale down these numbers to fit your case. So you decide to buy 178 shares to approximate 10% of your account in the stock. Cautiously, you set a mental or actual stop to 2% of your account, so you are willing to lose $2,500 approximately. Accordingly, you place a stop that is $14 below current market price, at $55/share. This is very low, but you are quite bullish right now, so it seems reasonable to do so. Here is the trade:
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If you were a cautious investor, you would have bought sufficient puts to cover your position, in case something went wrong. However, this "insurance" adds to your cost and cuts into your profits. If you look at the chart below, your risk is limited to $708, but your potential profits are also limited. If you manage a fund, your investors would probably say: I pay this guy to pck the good ones, not to limit my potential. Big money managers buy the insurance when stocks are likely to fall, not when they are rallying strongly, so following the earnings release, they remove their puts as the exhale in relief! As they do, the demand for puts (and calls for that matter) reduces, and this is reflected in a drop in implied volatility.
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Ironically, this strategy, known as "married puts" is the synthetic equivalent of a long call, without all the capital overlay, so if one was to do the married puts, wouldn't it be a better position to buy a number of calls to match the $708 risk? Someone may say that with the married puts, we "build wealth" around the stock position. In fact, we could not manage 50 call positions very well, because that is how many we would have if we were to risk 2% of our account on every trade.
With the PCCRC we could limit the number of positions, maximize the profits and limit the risk to 2% of our account. Further, we are not protecting ourselves against Vega, we embrace it!!
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In this PCCRC position, entered for BIIB just a couple of days after earnings, we are trying to take advantage of the apparently bullish outlook for the stock, as it outperformed the rest of the markets in recent days, and it actually broke up to new highs. At least one of the members of my private group suggested that by cutting the number of puts we could reduce the cash outlay to profit from the clearly bullish profile in the stock. When stocks appreciate, the PCCRC benefits from Delta, while Vega seem to get in the way, as implied volatility declines in rallies. However, I would argue, no one has a crystal ball and what may appear to be a very bullish scenario may be reversed just days later. in the case of BIIB the stock did just that! For stock traders, what happened to BIIB today could not have been pleasant. Right at the opening, the stock declined to $51.66, which would have triggered the stop loss and cause a loss of $3173.74, or 26% of our investment, or 2.54% of our account, which exceeded our projected max loss. An that is assuming that the your stop-loss order would have filled at the opening. In addition, who is to say that the stock could not have opened even lower?
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Nevertheless, assuming that we could have sold the stock right at the opening, here is the result:
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So, what if we have had the insurance of a couple of long puts to protect us?
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You could have certainly have limited the loss to only $708.20. In fact, because of implied volatility, the puts appreciate a little more than just by price movement, so we lose about $20 less... Perhaps good enough to cover the commissions.
What I think the greatest loss for the trader, however, is the impact to our ego. This kind of loss can only mean one thing: we are ill prepared to handle the loss and/or we just don't know about stocks to predict their performance, even with a couple of days after earnings. Mind you, I have been doing technical, fundamental and Elliott wave analysis for years. I certainly could not have predicted the fall in BIIB. It seems almost a random event in the history of the company what caused the fall. I can tell you by my own experience that recovery from this kind of hit is usually long and difficult, making it almost impossible to recognize opportunities in the Biotech sector, let alone any other industry.
That's right. Let's say that you had positions in the banking sector towards the end of 2007. Would you have been willing to close your losers in that sector and put your money in the oil sector? Recently, the rotation has been from Oil and Gas to Biotech, did you close your oil positions and bought some Biotech? probably not. We tend to stick with what is working and when it ceases to work we go through depression and lose our interest, ignoring the next movers. Very seldom do we let the markets tell us where to go and where to stay. I like to say that we are usually "proactive" rather than "reactive". This is a habit we learned when we were investors: buy low, sell high! go look for value. Even Elliott wave theory favors the contrarian behavior, as we look for stocks that are at the bottom of wave 2, hoping to catch wave 3's rally. When we see a stock going up from $55 to $73, like BIIB has been doing since early July, we'd probably say: oops! too late, the stock is high. Today's drop in the price of BIIB, would only have served to sediment your believe that you need to be looking for the next big mover, rather than trading the big mover itself.
No, I have learned to be REACTIVE. To only trade the stocks that are moving, the big fat pigs with lipstick on them, or the darlings of Wall Street if you will. Only I am ready for what may happen. This is why I entered a variation of this trade on BIIB, strictly following my rules that I have laid out in this blog as well as documents that are free for downloading:
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You are probably thinking: I would not go around parading my trades like this if I were you! particularly if they were losers. However, I want to take this opportunity to show you what really happen, and how is it that I have large winners, but only small losers, and sometimes even profitable trades from among the losers (that others would have to swallow).
The thing is, my PCCRC depends not only on Delta. Even though I have as many puts as I do calls, and they were all entered at the same strike price. You see, I have a huge Vega exposure. Which means that I can easily lose money as I can profit if IV goes down or up respectively. Note that my trade has a Vega of $326.06 which means that I would lose $326.06 for every 1% decline in implied volatility. So if the stock goes up, that is great because I have 108.96 positive deltas. Mind you I have more long than short calls, so I should make good money as the stock climbs. So my rationale for entering the position is decidedly bullish, but I am also ready for any eventuality, should bad news hit the stock, as it happened today with BIIB.
To be sure, I profit from strong rallies, and from Theta decay of the front month options, however, by far the most powerful force in the PCCRC is the fear of others, specifically fund managers, who buy puts when a stock declines strongly. Otherwise, the PCCRC would be a wash because as you see in the chart above, my max loss would be $2000, at about $60/share.
There might be some of you with more Vega experience that might be thinking, yeah but you are about to lose your shirt because of volatility crush!! Not really, I specifically design my trades to "Buy Low and Sell High...... Implied Volatility". Take a look at BIIB's IV on the day of entry:
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Following a set of simple rules, you can easily select to enter PCCRC's at time when IV is likely to rise. This protects you against volatility crush. But you are still OK if IV does not change or even goes down, as long as the stock is rising, which makes you a Delta winner. If the stock goes sideways up to 4 days before expiration, you may be a Theta winner. So the hard part of this for of trading is to find those Vega movers that happen to have low IV at this moment. BIIB was one of them.
So what DID happen to the PCCRC today? A winner!
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BUt not just any old winner. We got close to 100% return on our risk, and about 15% return on cash. The stock would have had to go up about $10 for the stock to make us that much money. As we know, stocks don't move that fast. But the real value of trading this way, and the very reason why my paper trading account is up about 70% in the last 13 months is because I transformed the big loser into a winner. If I had traded the stock, my account would have taken a 2.5% hit, instead it got a 1.25% increase. But what I consider most significant is that I am able to calmly observe the result, exit my position and move to the next winner, without dueling on BIIB any more. I think that this is what has really made the difference in my trading since 2005.
One last thing. Do you want to see where the fear of others went? take a look at todays spike in IV!
Not that I find joy in someone else's fear, I am just glad it is not mine.
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7 comments:
Hi Juan, I have just read your post of the 1st August, and decided to bring up a chart of BIIB. Imagine my surprise when I saw the carnage bought about by the 30% fall in BIIB stock price for the 1st August.
This is a massive fall, and one that I must find out as to what was the cause.
So, I went into my software and reconstructed the trade, day by day, very interested in where it ended up on the last trading day.
I'm a novice at this, however by my reckoning, even though the stock fell $23.00, the trade still made12% on risk, a fabulous return considering the alternatives.
I trust I have my figures correct.
My vol figures put volatilty at around 36% at the commencement of the trade, and as a result of that big selloff, the vol was about 52%.
As an aside, I don't use volatility percent to gauge where an option price is, but volatility "percentile".
Because an option can have an IV of 35% (= low ) however that may be it's maximum IV over the last 5 yrs.
Percentile, tells you where the IV is in relation to IV%, and is more accurate than just plotting IV %.
As an example, BIIB 's IV all time high for the last 5 years was 54%, back about mid November last year.
So just because 54% means it is about half way up the IV scale, does not equate to roughly half of it's potential percentage rise. 39% IV for BIIB is actually 64 percentile, and is getting quite high for going long.
This is my 2cents. I'm open to discussion
Thanks for the blog and your passionate interest in this subject, I have learnt quite a lot from you in the short time I have been on board.
Kind regards, Robert
I notice few things about the BIIB trade which doesn't look right. The first is the negative theta which mean the day you put on the trade, you are losing value because time decay.
That doesn't fit the entry criteria for your trade. You calculate the max risk to be $2000 out of 11000 investment. But the actual risk(loss) can easily be 70-80% ($7000-8000) if the volatility drop dramatically. Since volatility is even harder to predict than stock price movement, and nobody can predict stock price, volatility can go against you suddenly.
When you think volatility IV is low 36% and take the trade, it can go to 0% even faster than the stock price goes to 0. That's why profession market maker willing let you take this type of bet because when you least expected, they are going to take your money and you don't even have time to react. 40% iv can go to 0% in matter of hours for a total loss. I seen so many cases like that in the past.
Mickey, thank you very much for your comments. They give me a great opportunity to respond very specifically to a concern that other experienced option traders may have that probably have not traded nearly a fraction of the hundreds of PCCRC I have placed during the last 5 years. I want to reassure you that I keep 10 or more trades of these at any given time and that I also keep a paper trading account that the members of my group have been able to scrutinize over the last 13 months.
Over this period, none of my trades have lost more than the 2% risk I set for the trade. In fact very few even surpass 1% loss. You are right that the max loss you may have cannot be easily estimated, so I based my statement in observation rather than theoretical possibility.
Could volatility go from 36% to 0%? I have certainly never seen such a thing, so I would certainly enjoy looking at the many cases you have seen like that in the past.
Volatility CAN fall from 36% to say 26% if the company is taken over. In my experience, I have been lucky enough to be involved in a handful of cases like this and on average I have come out a big winner, why? because when a company is bought, the stock jumps 20-30% overnight, and then I profit from Delta, even when I.V. declines very strongly. If the price of purchase is not high enough, then the appreciation in your long calls is not enough to exceed the Volatility crush, but your loss (if any) is not likely to be big at all.
You see, most traders may shy away from volatility exposure because they do not understand their power. I look for situations in which IV is low and likely to rise. If you enter positions with very high volatility, and it collapses, you may lose a great deal of money. It is all in the knowledge of course, like everything else.
But you should not be scared to try it. I challenge you to paper trade a few PCCRC, strictly following my rules and then report back if you DO find a 70% loss. In fact I challenge you to find a loss that would exceed 2% of your account or 20% of your trade's capital.
Finally I urge you to PRODUCE those MANY CASES in which you got hurt because of volatility crush as IV declined to 0%. I am yet to see that.
Two cases where volatility can go to 0%without much time. One is the stock suspended trading at the exchange because violation of SCC rules and the other is a exchange trade fund (ETF) becomes a close end fund and no longer offer shares to general public. It is very common, but nobody ever mention about them because most people traded those took a total loss and kept to themself.
Mickey, the PCCRC benefits from strong moves in either direction. If a stock goes to 0, low IV is of no concern whatsoever, you are going to make your money on PUTS.
The PCCRC technics I use as I have stated clearly before, are meant for momentum stocks not for indices, ETF's or even blue chips. That is clearly stated in my rules.
All trades are entered with stock prices above $30.
Once again, I urge you to PRODUCE some of your MANY CASES in which IV crush went to 0 without a strong move in stock price. If you can give us some SPECIFIC examples. This should be easy because you say this is a very common event. Then we can see if my rules would not had excluded these situations.
Juan,
After spent some time reading your blog, I think that you have a very good Pccrc system. It is a good strategy trading volatility instead of depends totally on stock movement. I did come up with few questions; I appreciate it if you could give me some suggestions.
I see the difference between paper trading and real-time trading pccrcs because of execution and bid-ask slippage.
My criteria:
-Underline trade more than 1m shares daily
-Daily total option volume for the underline greater than 10000 contracts
-Bid-ask for single option less than 30 cents
-Bid-ask spread for ATM straddle less than 60 cents on the thinkorswim platform
-Beta of stock compared to SPX greater than 1 for momentum
1. Do you usually go into a trade with option volume, open interests, or bid-ask spread less than ideal? How easily can you execute Pccrc trades on thinkorswim? Amount of execution waiting time? What bid-ask spread do you give up?
I scanned the entire options universe for candidates in real-time today. Because of current high volatility environment and stocks tend to go sideways with no potential to move up big with jump in volatility. The potential candidates are limited.
Base on my criteria, I found BAC, CCJ, CHL, EL, EXM, FRO, MS, PBR, SYY … as potential candidates.
2. Does your option search engine come up with same candidate? My criterias are historical volatility has to be greater than IV, IV must be in the lower 1/3 of 2 years IV range. Front month Vol must be greater than back month Vol. Are the criterias too strict? What’s your take on it?
I appreciate your feedback!
MIchael, thanks for your contributions
Your strategy is different than mine, so chances are you would get different candidates and different results.
I encourage you to think outside the box and try our own approach, but remember that I have tested my strategy for years. First with a huge number of back testing trades, then paper trading and eventually my own trading. I hope you have done the same with your strategy.
I cannot comment intelligently about something I have not done. My guess is no better than yours, and definitely not better than your experience. So take it with a grain of salt.
1. Do you usually go into a trade with option volume, open interests, or bid-ask spread less than ideal?
These are usually a reflection of the liquidity of a stock. I don't give up too far of my middle price. If I had to do that, I'd rather not enter the trade. After all, I may have to exit at the wrong time and the exit trade not filling is frustrating and dangerous, to say the least.
How easily can you execute Pccrc trades on thinkorswim?
It depends on the liquidity. I love Think or Swim because I can enter my entire position with one single debit price, and I usually get a good fill. If I don't I get suspicious that the liquidity is not good and I simply avoid the trade.
Amount of execution waiting time?
The best approach is to enter my trades is between 11:30 and 12:00 pacific time. Volatility seems to be particularly low at that time. I start the trade at 11:30 and modify it every 5 minutes, and give it one last chance at 11:55. This is very general, but would give you a good starting point to try it out.
What bid-ask spread do you give up?
Start at the middle, and give up ¢5 at a time. If that is too small an increment, perhaps the bid/ask is too wide. Another indication that you are dealing with an iliquid stock.
Does your option search engine come up with same candidate?
Unless you use my system, I cannot see why they would compare. I'd rather avoid commenting on your method unless I do my own testing on it. I can only tell you with certainty what I do.
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