Options Trading Strategies – Wrong Use of Historical Volatility and Implied Volatility Crossovers

March 5, 2011 by  
Filed under Option Trading

Options Trading Strategies – Wrong Use of Historical Volatility and Implied Volatility Crossovers

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Home Page > Finance > Investing > Options Trading Strategies – Wrong Use of Historical Volatility and Implied Volatility Crossovers

Options Trading Strategies – Wrong Use of Historical Volatility and Implied Volatility Crossovers

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Posted: Jun 27, 2009 | Views: 257 |

Not all volatilities are constructed equal.   It is critical to differentiate between Historical Volatility and Implied Volatility, so retail traders learn how to trade options focused on what is material to theoretically price option spreads forward. Historical Volatility (HV) measures past price movements of the underlying asset recording the asset’s actual or realized volatility.   The more commonly known type of HV is Statistical Volatility, which computes the underlying assets return over a finite but adjustable number of days.   Let me explain what “finite but adjustable” means.   You can vary the number of days to measure the Statistical Volatility: for example, 5-10-50-200 days, that’s how time-based moving averages and momentum/oscillator studies are built.   Though, it is not the case with Implied Volatility. Implied Volatility measures expected values by repetitively refining bid-ask estimates.   These estimates are based on the expectations of buyers and sellers. The buyers and sellers (85+% of floor traded volume is driven by institutions, floor traders and market makers) behind the bid and ask values, who do change their estimates within the day, as new information be it macro-economic news or micro-economic data impacting the underlying product becomes available.   What is being estimated is the underlying asset’s future fluctuation with certain assumptions embedded into the changes in information of the underlying.   That refinement of bid-ask estimates must be completed within finite time-bound option expiration periods. That’s why there are monthly and quarterly option expiration cycles. You cannot change these expiration periods, either by shortening or lengthening the number of days, to “construct” a time period that gives you faster or slower crossover indicators. Why point out the wrong use of Historical Volatility and Implied Volatiity Crossovers? It is to caution you against the defective use of  HV-IV crossovers, which is not a reliable trading signal.   Remember, for a given expiration month, there can only be one volatility over that specific period.   Implied Volatility must leave from where it is currently trading at, to converge at zero on expiration date. Implied Volatility (be it IV for ITM, ATM or OTM strikes) must return to zero on expiry; but, price can go anywhere (up, down or stay flat). To continually sell “overpriced” and buy “under priced” options would eventually cause the implied volatility of every single non-zero bid option to line up exactly.   Meaning the phenomenon of IV’s “smiling” skew disappears, as IV becomes perfectly flat. This hardly happens, especially in highly liquid products. Take for example, the SPY, a broad-based Index; or, GLD – the SPDR Shares ETF in a fast market like Gold. With open interest at the non-zero bid strikes going into the thousands and tens of thousands, do you really think a retail off the floor trader is going to be allowed to “out price” the professional hedger on the floor?  Unlikely. Calls and Puts in highly liquid products, are like items in an inventory with high supply because there is high demand.   This type of inventory does not get “mispriced” because floor traders have to make a daily living from trading the Calls and Puts –they will refuse to carry the risk of mispricing overnight. So, what are the key considerations to banking in your edge as a retail trader? IV’s percentage impact on an option’s extrinsic value is much more sizeable for ATM and OTM strikes, versus ITM strikes which are laden with intrinsic value but lack extrinsic value.   Most retail option traders with an account size USD $25-$50K (or less), gravitate towards ATM and OTM strikes for reasons of affordability. The deeper the ITM you go, the wider the Bid-Ask spread becomes compared to the narrower Bid-Ask spread differences in the ATM or OTM strikes, making ITM strikes more costly to trade. When you trade IV, you are buying time decay for a rise in IV at a % point below; or, selling time premium for a drop in IV at a % point above the theoretical price of market value, that participants are willing to pay or sell for.   Depending on the market ranges of that day, price debit spreads to get filled at 0. 10-0. 15 below the Theoretical Price of the spread.   With credit spreads, raise the credit to sell the spread by 0. 10-0. 15 above the Theoretical Price of the spread.   The price you pay below; or, receive above the Theoretical Price of a spread is your edge, purely based on price-performance of Implied Volatility alone. Remember, you Theoretically Price a spread to fill the order for its forward value, never backward. Where can I learn how to trade options with consistent profits focused on Implied Volatility without Historical Volatility? Follow the link below, entitled “Consistent Results” to see a model retail option trader’s portfolio that excludes the use of HV and focuses on trading only IV. I’ll cite these actual historical events, to bolster the argument for removing Historical Volatility from your trading process altogether. 27 Feb, 2007: Widespread Panic from the sizeable China sell-off in equities. If you were trading the options of an index like the FXI which is the iShares product of China’s 25 largest and most liquid Chinese companies though listed in the US; but they are headquartered in China, you would have been impacted. While you can argue it’s possible to have market events recreate the ranges of the Dow, Nasdaq & S&P, how do you recreate the scenario of the VIX and VXN soaring 59% and 39%?22Jan, 2008: Fed cuts rates by 75 basis points prior to the scheduled policy meeting on Jan 30th, whereby the FOMC cut another 50 basis points on the date of the meeting.   If you were trading interest-rate sensitive sectors using the options on a Financial ETF or a Banking Index like the BKX; or, the Housing Index like the HGX, you would have been impacted. And in the current environment of rates being near zero, the FOMC while they still have a rate policy tool, they are unable to cut rates by the same number of basis points like before. What was a historical event is not successively repeatable going forward, not until rates are raised again and subsequently they get cut again. Question: How do you reconstruct history?  That is the history of events forming Historical Volatility.   The answer is in the real examples cited, as with any other financially related historical event – you cannot reconstruct history. You may be able to mimic parts of HV but you cannot repeat it in its entirety.   So, if you continue using HV-IV crossovers, you visually confuse yourself by searching for volatility “mispricing” patterns that you would like to see; but, you will end up with poor profit performance instead.   It makes more practical trading sense to focus purely on IV; then, diversify the trading of volatilities across multiple asset classes beyond equities. Where can I learn more about trading IV across multiple asset classes using only options, without having to own stock? Follow the link below (video-based course), that uses IV Mean Reversion/Mean Repulsion and IV Forecasting, as reliable methods to trade the implied volatilities across broad-based Equity Indexes, Commodity ETFs, Currency ETFs and Emerging Market ETFs.

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Clinton Lee –
About the Author:Please see Consistent Results http://www. homeoptionstrading. com/consistent_results/.
Here’s the summary for month-end July 2009 . . .
❑ Return: Profit/Start of Year Cash Balance = UP +115%! That’s +16. 43% Return per Month!
❑ Win/Loss Probability = 90. 20%. 9 Wins per 1 Loss. Average Win/Average Loss = $3. 66 Won per $1 Loss.
❑ Performance Ratio = (Win/Loss Probability) x (Average Win/Average Loss) = 90. 20% x $3. 66 = 3. 30.
❑ Positive Expectancy = $1,316 per trade.

Preview an original 55 hour video-based course for online options trading from home, at http://www. homeoptionstrading. com/original_curriculum. html
Purchase the curriculum and receive a $800 options basic course as a Bonus!

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Hi, Im looking for historical and implied volatility data on commodity options and was wondering if you know of any free websites that provide this info?
I am having more clients who are interesting to invest money in private placement program in INDIA. Please suggest me the best option for bullet trading. Dr. V. B. Rao Dasari drvbraodasari@gmail. com
What is the best approach to use forex signal in forex trading? Is this driven by fundamental aspect of trading?

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Please see http://www consistent results. homeoptionstrading. com / consistent_results /. Here? est? summary of month-end July 2009. . .????? Return: Income / Starting cash balance = 115% UP! That is 16. 43% Return per month !????? Win / Loss Probability = 90. 20%. 9 wins by a p? Loss. Average Win / Loss M = $ 3. 66 won by the p? Loss of $ 1 .????? Performance Ratio = (Win / probability of p? Loss) x (Win Media / P? Average loss) = 90. 20% x $ 3. 66 = 3. 30 .????? Positive expectation = 1,316 d? Dollars per OPERATION? N.Vista after an original course of 55 hours of v? Deo based on options trading in l? Line from home, at http://www. homeoptionstrading. com / original_curriculum. htmlCompra curriculum and receive a $ 800 course options b? musician as a bonus!

Options Trading Strategies ? Wrong Use of Historical Volatility and Implied Volatility Crossovers

July 10, 2010 by  
Filed under Option Trading

Not all volatilities are constructed equal.   It is critical to differentiate between Historical Volatility and Implied Volatility, so retail traders learn how to trade options focused on what is material to theoretically price option spreads forward. Historical Volatility (HV) measures past price movements of the underlying asset recording the asset’s actual or realized volatility.   The more commonly known type of HV is Statistical Volatility, which computes the underlying assets return over a finite but adjustable number of days.   Let me explain what “finite but adjustable” means.   You can vary the number of days to measure the Statistical Volatility: for example, 5-10-50-200 days, that’s how time-based moving averages and momentum/oscillator studies are built.   Though, it is not the case with Implied Volatility. Implied Volatility measures expected values by repetitively refining bid-ask estimates.   These estimates are based on the expectations of buyers and sellers. The buyers and sellers (85+% of floor traded volume is driven by institutions, floor traders and market makers) behind the bid and ask values, who do change their estimates within the day, as new information be it macro-economic news or micro-economic data impacting the underlying product becomes available.   What is being estimated is the underlying asset’s future fluctuation with certain assumptions embedded into the changes in information of the underlying.   That refinement of bid-ask estimates must be completed within finite time-bound option expiration periods. That’s why there are monthly and quarterly option expiration cycles. You cannot change these expiration periods, either by shortening or lengthening the number of days, to “construct” a time period that gives you faster or slower crossover indicators. Why point out the wrong use of Historical Volatility and Implied Volatiity Crossovers? It is to caution you against the defective use of  HV-IV crossovers, which is not a reliable trading signal.   Remember, for a given expiration month, there can only be one volatility over that specific period.   Implied Volatility must leave from where it is currently trading at, to converge at zero on expiration date. Implied Volatility (be it IV for ITM, ATM or OTM strikes) must return to zero on expiry; but, price can go anywhere (up, down or stay flat). To continually sell “overpriced” and buy “under priced” options would eventually cause the implied volatility of every single non-zero bid option to line up exactly.   Meaning the phenomenon of IV’s “smiling” skew disappears, as IV becomes perfectly flat. This hardly happens, especially in highly liquid products. Take for example, the SPY, a broad-based Index; or, GLD – the SPDR Shares ETF in a fast market like Gold. With open interest at the non-zero bid strikes going into the thousands and tens of thousands, do you really think a retail off the floor trader is going to be allowed to “out price” the professional hedger on the floor?  Unlikely. Calls and Puts in highly liquid products, are like items in an inventory with high supply because there is high demand.   This type of inventory does not get “mispriced” because floor traders have to make a daily living from trading the Calls and Puts –they will refuse to carry the risk of mispricing overnight. So, what are the key considerations to banking in your edge as a retail trader? IV’s percentage impact on an option’s extrinsic value is much more sizeable for ATM and OTM strikes, versus ITM strikes which are laden with intrinsic value but lack extrinsic value.   Most retail option traders with an account size USD $25-$50K (or less), gravitate towards ATM and OTM strikes for reasons of affordability. The deeper the ITM you go, the wider the Bid-Ask spread becomes compared to the narrower Bid-Ask spread differences in the ATM or OTM strikes, making ITM strikes more costly to trade. When you trade IV, you are buying time decay for a rise in IV at a % point below; or, selling time premium for a drop in IV at a % point above the theoretical price of market value, that participants are willing to pay or sell for.   Depending on the market ranges of that day, price debit spreads to get filled at 0. 10-0. 15 below the Theoretical Price of the spread.   With credit spreads, raise the credit to sell the spread by 0. 10-0. 15 above the Theoretical Price of the spread.   The price you pay below; or, receive above the Theoretical Price of a spread is your edge, purely based on price-performance of Implied Volatility alone. Remember, you Theoretically Price a spread to fill the order for its forward value, never backward. Where can I learn how to trade options with consistent profits focused on Implied Volatility without Historical Volatility? Follow the link below, entitled “Consistent Results” to see a model retail option trader’s portfolio that excludes the use of HV and focuses on trading only IV. I’ll cite these actual historical events, to bolster the argument for removing Historical Volatility from your trading process altogether. 27 Feb, 2007: Widespread Panic from the sizeable China sell-off in equities. If you were trading the options of an index like the FXI which is the iShares product of China’s 25 largest and most liquid Chinese companies though listed in the US; but they are headquartered in China, you would have been impacted. While you can argue it’s possible to have market events recreate the ranges of the Dow, Nasdaq & S&P, how do you recreate the scenario of the VIX and VXN soaring 59% and 39%?22Jan, 2008: Fed cuts rates by 75 basis points prior to the scheduled policy meeting on Jan 30th, whereby the FOMC cut another 50 basis points on the date of the meeting.   If you were trading interest-rate sensitive sectors using the options on a Financial ETF or a Banking Index like the BKX; or, the Housing Index like the HGX, you would have been impacted. And in the current environment of rates being near zero, the FOMC while they still have a rate policy tool, they are unable to cut rates by the same number of basis points like before. What was a historical event is not successively repeatable going forward, not until rates are raised again and subsequently they get cut again. Question: How do you reconstruct history?  That is the history of events forming Historical Volatility.   The answer is in the real examples cited, as with any other financially related historical event – you cannot reconstruct history. You may be able to mimic parts of HV but you cannot repeat it in its entirety.   So, if you continue using HV-IV crossovers, you visually confuse yourself by searching for volatility “mispricing” patterns that you would like to see; but, you will end up with poor profit performance instead.   It makes more practical trading sense to focus purely on IV; then, diversify the trading of volatilities across multiple asset classes beyond equities. Where can I learn more about trading IV across multiple asset classes using only options, without having to own stock? Follow the link below (video-based course), that uses IV Mean Reversion/Mean Repulsion and IV Forecasting, as reliable methods to trade the implied volatilities across broad-based Equity Indexes, Commodity ETFs, Currency ETFs and Emerging Market ETFs.

Please see http://www consistent results. homeoptionstrading. com / consistent_results /. Here is a summary of month-end July 2009. . . ? Return: Profit / Beginning of Year Cash Balance = UP 115%! That is +16. 43% Return per month! ? Win / loss probability = 90. 20%. 9 wins for one loss. Average Win / Average Loss = $ 3. He won 66 for each $ 1 Derrota.Proporci

Options Trading Strategies ? Treat Implied Volatility of Calls Separate From the IV of Puts

July 7, 2010 by  
Filed under Option Trading

The Implied Volatility (IV) of Calls needs separate treatment from the IV of Puts. Also, for specific options trading strategies treat the IV of both Puts and Calls as a combined bundle. Each option at each strike implies its own individual percentage value of the underlying product’s future volatility. This makes it unique from any other option within the same chain of a given expiry month. The individuality of an option’s percentage value at each strike is what draws the “smile” in the IV’s Skew. So, while an ITM Call has a corresponding OTM Put sharing the same strike, conversely an ITM Put has an OTM Call counterpart at the same strike, the Call must be treated uniquely as a Call and the Put uniquely as a Put. The more ITM an option becomes, its intrinsic value becomes higher and its extrinsic value is lowered. Conversely, at the same strikes where an ITM Call (or Put) gets deeper In The Money, the corresponding Put (or Call) becomes further OTM. The more OTM an option becomes, its extrinsic value rises higher and its intrinsic value is lowered. Even with ATM options, where the Call’s Delta is exactly 0. 50 and the Put also has a Delta of exactly 0. 50, the Implied Volatility on either side of that same ATM strike is different. While Calls and Puts appear side-by-side for a given strike, they are not identical twins to simply trade places. Think of it this way, each option has its own Intrinsic-Extrinsic fingerprint that makes that Call or Put identifiable only to itself. The logic for treating the Implied Volatility of Calls separate from the IV of Puts becomes obvious in the construction of specific spread types. Let’s break down the components making up the following spreads. A Vertical Call, be it a Credit Vertical or a Debit Vertical only uses ALL Calls. No Puts are used in the spread’s construction. A Back Ratio Call is typically done as a Debit spread. It is effectively Net Long an additional Call. The spread only uses ALL Calls. There are no Puts involved. A Vertical Put, be it a Credit Vertical or a Debit Vertical only uses ALL Puts. There are no Calls involved. A Back Ratio Put is typically done as a Debit spread. It is effectively Net Long an additional Put. The spread only uses ALL Puts. There are no Calls involved. A Put Calendar is typically initiated for a small Debit. It only uses ALL Puts. A Call Calendar is comprised of Calls ONLY. Now, let’s compare the above spreads with these other types of spreads. An Iron Condor is typically constructed as a Credit spread. It uses BOTH Calls and Puts. Remember, a short Iron Condor is made up of a Credit Vertical Call combined with a Credit Vertical Put. A Straddle/Strangle is typically constructed as a Debit spread. It combines BOTH a Call and a Put. Clearly, there are more spreads that require the Implied Volatility to be differentiated between Calls versus Puts, compared to the use of a combined IV. So, in choosing a data provider of Implied Volatility, make sure you get the IV data of Calls that is set apart from the IV of Puts; as well as, data that combines the IV of Calls and Puts together. That means 3 sets of IV data in one service. We have just established the structural logic for decoupling the IV of Calls from the IV of Puts. How do you apply this to a trade? Here’s how. A long Vertical Call is a Debit spread. By definition of it being a negative Theta spread, also means it is a positive Vega trade. Positive Vega means the spread needs IV to rise. There is a need to forecast an increase in Implied Volatility within 30-60 days, specific to the IV of Calls for a long Vertical that expires between 90-120 days. The IV forecast must be specific to the traded product itself. Likewise, this technique is relevant for a Back Ratio Call. Apply the same logic for a Debit Vertical Put to the IV of Puts for that traded product and similarly for the Back Ratio Put. The variation of this is in a Straddle/Strangle, which is still a Debit spread, so there is still a need to forecast a rise in IV, except the IV combines both Call IV plus Put IV. A short Vertical Call is a Credit spread. By definition of it being a positive Theta spread, also means it is a negative Vega trade. Negative Vega means the spread needs IV to fall. There is a need to forecast a decrease in Implied Volatility within 30 days, specific to the IV of Calls for a short Vertical that expires between 30-50 days. Again, the IV forecast must be specific to the traded product itself. The same logic applies to a credit Iron Condor. However, the relevant IV to forecast is the IV of Calls combined with the IV of Puts. The Calendar requires unique treatment. Why? The short leg expires in a different month from the long leg. Due to this inter-month expiration in its construction, the Implied Volatility forecast requires a drop in the front month of its short leg but an IV rise in subsequent back months of the Calendar’s long leg. Remember, with a Calendar, if it is a Put Calendar, forecast only the IV of Puts. Similarly, if you construct a Call Calendar, only the forecast of the Call IV applies. Is there a working example of a consistently profitable portfolio that treats Implied Volatility of Calls separate from the IV of Puts? Yes. Follow the link below, entitled “Consistent Results” to see a model retail option trader’s portfolio that applies this logic. To conclude, I’ll use an analogy. Though an egg comes in one shell, the yolk is separated from the white, for a different purpose that distinguishes the individual parts of that same egg. Treat Implied Volatility of an option’s anatomy in the same way.

Please see Consistent Results http://www. homeoptionstrading. com/consistent_results/.
Here’s the summary for month-end July 2009 . . .
? Return: Profit/Start of Year Cash Balance = UP +115%! That’s +16. 43% Return per Month!
? Win/Loss Probability = 90. 20%. 9 Wins per 1 Loss. Average Win/Average Loss = $3. 66 Won per $1 Loss.
? Performance Ratio = (Win/Loss Probability) x (Average Win/Average Loss) = 90. 20% x $3. 66 = 3. 30.
? Positive Expectancy = $1,316 per trade.

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