Saturday, October 04, 2008

Volatility

What a wild market we've seen. Volatilities reached levels not seen for 5 or 6 years. The Dow was down almost 800 one day and up nearly 500 by the close of the following day. These have been hard, fast swings and they can be very difficult to trade. Straight directional trades have been dangerous. What can a trader do in circumstances like these to protect himself or herself? In "Trade Your Way to Wealth" I described some strategies that can save the day in circumstances such as these. I personally use protective puts to "insure" stock positions at times and I often place collars on high priced stocks. Collars, as I describe in the book, can even be set up with zero risk and even with an assured profit at entry. As an example, back in June, I bought shares of Baidu.com (BIDU) at just over $323 a share. A couple of days ago, I sold the stock for $230 a share. It had gone down more than $90 a share, but I made a profit overall. When I bought the stock, I also bought the $320 puts and sold the $340 calls. The call premium just about paid for the puts I bought. Between June and the end of September, I bought back then resold calls against my position about 7 times, making a profit on the individual trades each time. When I closed my positions, though I took a big loss on the stock, I realized a big gain on selling the protective puts. In these transactions, I initially used the premium I was paid for the call to pay for the protective put. Thereafter I traded the calls depending upon movement in the stock price to achieve an overall gain from the stock and option trades.

I describe the BIDU collar to illustrate that there are strategies by which we can protect ourselves on the one hand and earn good profits even when we are in a market that is as wildly unpredictable as our current situation. In order to accomplish those trades, we need to acquire the knowledge. I cringe to think what may be happening to the fellow I recently wrote about who was going to learn by doing. I have no doubt that recently he has learned quite a lot about what markets can do. Circumstances like those we have been experiencing can provide a much more costly education than what one may pay to buy a good trading book, or a DVD, or a seminar, or for private coaching.

Another way to work wildly volatile markets such as those we have seen recently may be to sell option premium. When implied volatility is high, that means that option prices are high relative to their norm. Selling options to open a position when prices are high and then buying later to close the position after volatility has dropped and some time has passed can lead to some very profitable trades. The trader, for example, could do that by selling naked options with the risk attendant to those strategies or he can sell spreads (though they somewhat negate the high volatility) for pretty decent potential returns on a specifically limited risk.

Investors who are not familiar with volatility trading or who don't know how to place and trade collars or who don't understand or won't buy protective puts may best be served by remaining on the sidelines until volatility diminishes. I always remind myself that being in cash is a position, too. Depending upon your level of knowledge and individual risk tolerance, that may not be a bad place to be when volatility is soaring.

by Bill Kraft, Editor
Copyright 2008, Makin' Hay, Inc.
All Rights Reserved


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To comment on Bill's article click on the "comments" link below.

20 comments:

Anonymous said...

Hi Bill;
I have been reading and following you newsletter for about a year now and enjoy your commentary. However given the losses I have sustained trying to trade options (~290k) over the last 2 years despite having read studied and tried, in my opinion to employ the tricks you relate, I can only say that you vastly underestimate your own talent. Or maybe not.
Even trying to use other peoples' advice as you offer in your services has proved ineffective despite slavish attention to following instructions.
All I can say is my hat is off to you trading Baidu as you did.
Aaron
stimpykcat@yahoo.com

Anonymous said...

Good article Bill. Thanks. I'm curious though, what's the advantage of trading options on an existing stock position instead of just stopping out and perhaps reversing. For a fund I could see where size of the underlying position would be restrictive to unwind and it may be more advantageous/cost-effective to use options as a synthetic stop but an individual's account usually doesn't reach the same size and thus make it as cost effective to employ a strategy using options for stops given the spreads and commissions? What are your thoughts on this?

Thanks,
Brian.

Anonymous said...

Bill,

I have tried covered calls with some success and some failures (LEH), etc. I have found it critical with CC's to be on the right side of trend. I'm with Fidelity and they will only authorize me to use CC options. Any work-around you would advise?

Thanks, JIM

Dario said...

Hi Bill;

I think the collar is a strategy to minimize the losses, but if the stock goes down, it is literally impossible to make money with this strategy (At least that's what the theory says).

Using a specific example with closing prices on Friday in Stock POT:

Buy 100 POT @ $95.36 ------ $9,536.00
Buy 1 OCT08 90 Put @ $7.10 ------- $710.00
Sell 1 OCT08 100 Call @ $7.00 ------ ($700.00)

Cost $9,546

If the stock falls below 95 is the maximum loss -$546. But below $ 95 there is no profit by using a collar.

Unless there is some other secret that unknown.


It is no more advisable in this situation of high volatility Strangles use?

If one is not sure which direction the market will take, the high volatility (with a lot of volatility in stocks) allow profits no matter which direction the stock moves, and with a considerably low risk.

Buy 1 POT OCT08 90 Put @ $7.10 ------- $710.00
Buy 1 POT OCT 2008 100 Call @$7.00 ------- $700.00

Cost $1,410

As you explained in his book, in this particular case, if the stock rises above $ 115 or falls below $ 75, we get a win, which is the greater, the larger the movement, no matter the direction.

Thanks

Bill Kraft, MarketFN.com said...

Thanks for writing, Aaron. You have definitely chosen to jump in during some pretty difficult trading times.
Bill

Bill Kraft, MarketFN.com said...

Hi Brian and thanks for writing. Stopping out and even reversing a stock position can certainly be an effective way to go. However, options also provide some powerful protection. For example, if you buy a protective put, you know you can force someone to buy your stock anytime before expiration at the strike price of the put you bought. Placing a stop does not have that guarantee. If you set a stop and a stock you own gaps down, for example, you will be stopped out, but you will have no guarantee that you will get out at any specific price. Suppose you own XYX at $78 a share and have a stop at $75. Bad news comes out overnight and the stock opens the next morning at $40. You will not get $77, you'll only get something around $40. On the other hand if you owned a $75 put, you could either exercise the put and get $75 a share or just sell the put and get the in the money portion (+$35 a share) plus any time value. Using a collar where you buy a protective put and pay for it by selling an out of the money call can sometimes even guarantee a profit. Those are just a couple of examples. Hope that helps.
Bill Kraft

Bill Kraft, MarketFN.com said...

Hi Jim. Writing covered calls is definitely a bullish strategy and should only be used with extreme caution if the market is bearish. Some buy and hold investors do write out of the money calls each month but try to avoid being called out. "Purists" generally like to be called out or certainly don't mind when they are. I'm not sure what you mean when you say Fidelity "...will only authorize you to use CC options." If you mean that is the only option strategy they permit you to use and you can't buy directional options or create spreads (and you know what you are doing with strategies other than covered calls), I would suggest you request they raise your level. If they won't, I would suggest you look for another broker who will permit you to do what you want with your own money.
Bill Kraft

Bill Huffer said...

Dear Jim,
Great article. Timely and incisive
observations. People ought to pay
attention to it, or suffer more.
Thanks for all your columns.
Sincerely,
Bill Huffer

Glenn said...

Bill,

I recently read advice (can't remember where) that implied volatility should be gauged "high" or "low" relative to statistical volatility. According to this philosophy, even very high implied volatility values should be regarded as "low" if they are much lower than the statistical volatility. This is exactly what I observed for October SPX strikes through most of the recent volatile swings....leading me to conclude it was a poor opportunity to "sell volatility". What are your thoughts on this?

Anonymous said...

Hi Bill,

Thank you for your thoughtful work and article. I have read your book and learned much of value from it.

On the BIDU collar trade you reference, which month put did you initially buy and which month call did you initially sell?

Thank you,

Eric

Bill Kraft, MarketFN.com said...

Dario, what you say about it being impossible to make money with collars is simply untrue. I make money with collars quite regularly as I set out in my example in the Newsletter this weekend. Good collars are not available on all stocks at all times. It takes some work and you need to know what you are doing, but don't think it is impossible to make money with collars.
Bill Kraft

Bill Kraft, MarketFN.com said...

Well, Bill, thanks for the compliments, I sincerely appreciate them.

However, my name is Bill, not Jim.
Bill Kraft

Bill Kraft, MarketFN.com said...

Great question, Glenn. There are two types of volatility. Implied volatility (IV) is the market's prediction of what is going to happen and statistical (also called historical) volatility (SV) is a measure of what has happened in the past. In general, high implied volatility indicates that options are relatively expensive so it may be a good time to sell premium. However, it is also important to see the relationship of IV to SV. If IV is in the high *percentiles* (not the raw percentage numbers) and is above SV, then the option is both expensive AND overvalued. If the IV is in a high percentile and SV is in an even higher percentile, then though the option may be considered expensive but still undervalued. Of course, these are generalities but IV percentile higher than SV percentile means overvalued and IV percentile lower than SV means undervalued. Currently, both SV and IV have been in very high percentiles and as a volatility trader I would rather see a spread between IV and SV percentiles. Better to sell high priced and overvalued.
Bill Kraft

Bill Kraft, MarketFN.com said...

Thanks, Eric. On the BIDU trade, I started by buying the stock on 6/13. At the same time, I bought the Jan '09 320 puts and sold the Jan '09 340 calls. Thereafter, I traded multiple times in and out of various strike and expiration calls until 9/23 when I finally bought to close the last call position. I sold the original puts on 9/29 for a $43.30 a share profit. The remainder of my plays consisted of dynamically trading the calls. Thanks for buying my book, Eric. I'm glad it was helpful.
Bill Kraft

Dario said...

hey Bill, I want to apologize to me, but I did not give numbers.

I really appreciate help with this.

In the trade of Bidu said that you had a profit when the stock fell $ 90 using a collar.

In addition, you said that you have earned a profit of $ 43.30 a share selling puts.

If each stock lost $ 90 .- and each put won $ 43.30 a share, the result is a loss.

also said:

"I bought back then resold calls against my position about 7 times, making a profit on the individual trades each time."

These trades with calls you provided a ganacial such that it can cover the loss of $46.7 per share?

I do not quite understand how it is that you picked a gain in the total operation with the collar, when the stock fell.

Excuse the inconvenience. Thank you.

Bill Kraft, MarketFN.com said...

Hi Dario. I also wrote that the remainder was made up selling and buying back the calls dynamically. I started with the stock, the puts, and sold calls. I later bought the original calls back at a profit and then sold other calls. I repeated that process several times as BIDU's price fluctuated. When the stock rose, I sold calls, when it dropped, I bought them back and did that several times. Of course, that enabled me to earn my profit. However, there are often collars to be found where you can actually set up positions to guarantee a profit even if you do nothing. In those cases, I would not expect as great a profit, but I could be secure in the knowledge that there would be one.
Bill Kraft

Anonymous said...

Hi, Bill:
I have been following your newsletter for over a year. I really like it and feel I've learned a lot. I wish I had read your Oct.4 article years ago. I also wonder if you could recommend me any good books and seminars? BTW, I am going to buy your "Trade your way to wealth". Any other books?
Another favor to ask. Could you give me more detail information about how you did with BIDU (I am very interested in how you bought back covered call and re-sold another one. I did similar one before with a loss)? What did you do different?
Thanks. Mack
mackshen@yahoo.com

Bill Kraft, MarketFN.com said...

Hi Mack.

I like a couple of books besides mine for folks who are interested in expanding their trading knowledge. One is Doug Sutton's Beginning Investors Bible and another is Dr. Alexander Elder's Trading for a Living. I should tell you I finished the manuscript of a new book dealing with streams of income for John Wiley & Sons. It goes into production this week and probably will be available on Amazon.com and Wiley.com around February.

I go into detail about dynamically trading a collar in Trade Your Way... I need to let you know that in the example I give on page 88 of the book, I somehow used the wrong figures or date at one point. However, the principle set out is accurate and one I use in trades like the BIDU trade I wrote about last weekend. Thanks for getting my book and for your kind words. I'm glad the articles have been helpful.

Bill Kraft

Anonymous said...

These past few days I was reminded of what you preach, and how important it is to "plan your trade and trade your plan." When I read that originally I came up with a plan that agreed with the risk-taker in me: to buy slightly out-of-the-money LEAPS, half of them calls on stocks I was bullish on, and the other half puts on stocks I was bearish on. This pretty much guarantees that if the tide of the market at large indiscriminately pushes all stocks in one direction, at least half of my portfolio will benefit from it.

Did I trade my plan? No. I bought too many calls, and not enough puts.

You can probably tell that I need to read your book. There are probably better plans outlined in it.

Your newsletter is great, by the way, and your wisdom is priceless.

M.

Bill Kraft, MarketFN.com said...

Thanks, M. I don't want to mislead you. "Trade Your Way to Wealth" does not set out specific plans because each plan must be specific to the individual. It does, however, include important elements for any plan and discusses in some depth how a trader can go about using those elements to create his specific plan. By the way, on the preponderance of calls you have been long in the past few weeks, you are not alone. It seems that many traders have a tendency to be heavier on the bullish side even in a bear market. It is something to be aware of and as I discuss in "Trade Your Way to Wealth", may be an indication of a need to change exit strategy.
Bill Kraft