Expmonthly Vol3no3 May 4 5

7/27/2019 Expmonthly Vol3no3 May 4 5

1/24

May 2012 | Vol. 3 No.

MONTHLYT H E O P T I O N T R A D E R S J O U R N A L

Are Bonds Telling the

VIX Next Move?

An Interview with

Mark Sebastian

Managing the Short Time Spread


2/24

www.expiringmonthly.com May 2012 2

ONTHLYT H E O P T I O N T R A D E R S J O U R N A L

editorial

Bill LubJred Woodrd

Mrk Sebstin

andrew Giovinzzi

design/layout

Luren Woodrow

contact information

Editoril comments: [email protected]

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Expiring Monthl PresidentMrk Sebstin: [email protected]

Phone: 773.661.6620

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contents

4 e n

Bill Luby

5 a x

The Expiring Monthly Editors

7 m s t s

Andrew Giovinazzi

8 a B t Vix n mv?

Mark Sebastian

10 r u: e V

p (p 2)

Jared Woodard

11 expiring monthly feature

t e V m

Bill Luby

16 e m iv

Mark Sebastian

Jared Woodard

19 floorstories: h lq pv

p o

Andrew Giovinazzi

21 followthattrade: g a

n g

Jared Woodard

23 backpage: t e B

Mark Sebastian
mailto:editor%40expiringmonthly.com?subject=mailto:marks%40expiringmonthly.com?subject=http://www.optionsclearing.com/about/publications/character-risks.jsphttp://www.optionsclearing.com/about/publications/character-risks.jsphttp://www.optionsclearing.com/about/publications/character-risks.jsphttp://www.optionsclearing.com/about/publications/character-risks.jspmailto:marks%40expiringmonthly.com?subject=mailto:editor%40expiringmonthly.com?subject=


3/24


About the

Expiring Monthly Team

Bill Luby

Bill is privte investor whose reserch

nd trding interests focus on voltilit,

mrket sentiment, technicl nlsis,

nd ETFs. His work hs been hs been

quoted in the Wll Street Journl,

Finncil Times, Brrons nd other

publictions. a contributor to Brrons

nd Minnville, Bill lso uthors the VIX

nd More blog nd n investment

newsletter from just north of Sn

Frncisco. He hs been trding options since 1998.

Prior to becoming full-time investor, Bill ws business strt-

eg consultnt for two decdes nd dvised clients cross

brod rnge of industries on issues such s strteg formul-

tion, strteg implementtion, nd metrics. When not trding or

blogging, he cn often be found running, hiking, nd kking

in Northern Cliforni.

Bill hs Ba from Stnford Universit nd n MBa from

Crnegie-Mellon Universit.

Jared Woodard Jred is the principl of CondorOptions. With over decde of

experience trding options, equities,

nd futures, he publishes the Condor

Options newsletter (iron condors) nd

ssocited blog.

Jred hs been quoted in vrious

medi outlets including The Wll

Street Journl, Bloomberg, Finncil

Times alphville, nd The Chicgo Sun-Times. He is lso con-

tributor to TheStreets Options Prots service.

In 2008, he ws proled s top options mentor in Stocks,

Futures, nd Options Mgzine. He is lso n ssocite member

of the Ntionl Futures assocition nd registered principl of

Clinmen Finncil Group LLC, commodit trding dvisor.

Jred hs msters degrees from Fordhm Universit nd the

Universit of Edinburgh.

Mark Sebastian

Mrk is professionl option trder

nd option mentor. He grduted

from Villnov Universit in 2001 with

degree in nnce. He ws hired into

n option trder trining progrm b

Group 1 Trding. He spent two ers

in New york trding options on the

americn Stock Exchnge before

moving bck to Chicgo to trde SPX

nd DJX options For the next ve

ers, he trded vriet of option products successfull, both

on nd o the CBOE oor.

In December 2008 he strted working s mentor t Sheridn

Option Mentoring. Currentl, Mrk writes dil blog on ll

things option trding t Option911.com nd works prt time

s risk mnger for hedge fund. In Mrch 2010 he becme

Director of Eduction for new eduction rm OptionPit.com.

AndrewGiovinazzi andrew Giovinzzi strted his creer in

the nncil mrkets fter grduting

from the Universit of Cliforni, Snt

Cruz with B.a. in Economics in 1989.

He joined Group One, Ltd. nd quickl

becme member of the Pcic Stock

Exchnge (nd lter the CBOE), where

he trded both equit nd index

options over 15 er spn. During

tht period he never hd down er.

at the sme time, andrew strted nd rn the Designted

Primr Mrket Mrker post for GroupOne on the oor of the

CBOE. It becme one of the highest-grossing posts for the

compn in 1992 nd 1993. While ctivel trding, andrew ws

instrumentl in creting nd mnging n option trder trin-

ing progrm for Group One.

He left Group One, Ltd. to co-found Henr Cpitl Mngement

in 2001. andrew then joined aqumin LLC (20082011) to help

bring 3D quoting nd nlsis to nncil dt. He is Chief

Options Strtegist t Option Pit.


4/24


Editors

NotesBill Luby

The M options expirtion ccle sw stretch in which the

VIX rose in eleven out of thirteen ds, s the mrkets fret-

ted over the outcome of the next election in Greece nd the

implictions for the euro zone nd cross the globe. While

the voltilit indices hve risen, there seems to be big

disconnect between the mrkets current expecttions for

future voltilit nd some of the dire predictions bout the

future of the euro zone. The M edition ofExpiring Monthly

ttempts to ddress some of the issues relted the current

sitution from number of perspectives.

andrew Giovinzzi exmines short time spreds such s

the recent London Whle trde t JP Morgn, where losses

re now likel to top $7 billion. andrew focuses on how to

understnd nd mnge the risks inherent in these short

time spreds. In seprte rticle, andrew exmines the

evolution of how liquidit providers hve priced options, with

n emphsis on how trding implied voltilit hs come to

dominte current thinking.

Mrk Sebstin hs thought-provoking piece which

looks t the spred between TLT (the 20+ yer Tresur

Bond ETF) nd the VIX. This rticle hs some interest-

ing implictions for risk mngement s well s trding

strtegies.

In Risk or Uncertint: Explining the Vrince Risk

Premium (Prt 2), Jred Woodrd extends his nlsis of

ambiguit aversion nd Vrince Premium, recent pper

b Jinjun Mio, Bin Wei, nd Ho Zhou tht oers n mbi-

guit-bsed explntion for vrince premium.

Jred lso hs chnce to turn the tbles little, mking

Mrk Sebstin the subject of this months feture interview

Jred tlks with Mrk bout wide rnge of topics from con-

sulting to hedge funds on risk mngement to order ow to

mentoring options trders.

I m responsible for this months feture rticle: The

Expnding Voltilit Megplex. In this rticle I trce the evo-

lution of voltilit indices nd nlze where the re going

s well s some of the criticl success fctors.

Jred Woodrd tkes the Follow Tht Trde segment in

n intriguing direction, running with Je Gundlch notion

of men reversion pirs trde tht pits apple ginst

nturl gs.

Once gin, the EM tem is bck to nswer reder ques-

tions in the ask the Xperts segment. Lst but not lest, Mrk

Sebstin mns the Bck Pge, where he opines bout big

losing trdes, relistic expecttions nd the lure of some

get-rich-quick options trding schemes.

as lws, reders re encourged to send questions,

comments or guest rticle contribution ides to editor@

expiringmonthl.com.

Hve good expirtion ccle,

Bill Lub

Contributing Editor
mailto:editor%40expiringmonthly.com?subject=mailto:editor%40expiringmonthly.com?subject=mailto:editor%40expiringmonthly.com?subject=mailto:editor%40expiringmonthly.com?subject=


5/24


Q: I am just starting to do

some international busi-

ness, and a customer

needs to pay me in euros.

This is for a large transac-

tion, and I know that I will

receive a specic number

of euros in about a month.

Normally, I wouldnt care,

but given everything going

on in Greece, I think I

should hedge that currency

exposure, since I do every-

thing else in U.S. dollars. I

thought about buying puts

on FXE, but with implied

volatility being where it is,

I wonder if there is a better

approach here?

James D.

A: Ive ctull received

this question from few

people over the lst severl

weeks, nd its n impor-

tnt thing to be wre of if

ou do business in multiple

countries.

Remember tht n time

ou bu n option, oure

lws ping more thn

the intrinsic vlue of the

underling sset. Since

oure not tring to express

prticulr view bout

voltilit here, this is

sitution where I would sug-

gest using the underling

insted of using options,

either vi the 6E futures or

the FXE ETF.

Right now, one euro is

worth bout 1.27 U.S.

dollrs. If oure going to

receive xed mount of

euros in the future nd ou

wnt to lock in the current

exchnge rte vs. dollrs,

ou could sell short thefutures in the pproprite

size: one contrct t the

CME equls 125,000 euros,

or there is mini contrct

sized t 62,500 EUR. If

our trnsction is smller

thn tht, ou cn use the

FXE ETF.

as side note, in ll the

brethless commentr in

the nncil medi bout

the derivtives losses of J.P.

Morgn nd other bnks

nd funds, its es to for-

get tht futures nd options

hve been round since

ncient times, nd serve

ver vluble economic

function when properl

regulted.

Jred

Q: I am writing to you

because if you attempt

to download daily closing

VIX data from the CBOE

you get two dierent data

series! You get one if you

download it from here

(http://www.cboe.com/

publish/ScheduledTsk/

MktDt/dthouse/vix-

rchive.xls and http://

www.cboe.com/publish/

ScheduledTsk/MktDt/

dthouse/vixcurrent.csv)

and another dierent one ifyou download it from here

(http://www.cboe.com/

micro/buwrite/dilprice-

histor.xls)!

All told there are 45 data

points that are dierent.

Could you tell me which

data series is the right one?

Alberto

A: Prt of the reson there

re multiple sets of dt

is tht the methodolog

used to clculte the VIX

ws chnged in September

2003. Dt set #1 below

included dt tht ws

historicll reconstructed

for the new VIX clcul-

tion methodolog tht

went into eect in 2003

nd includes ll VIX dt

from 19902003. Dt set

#2 picks up with the new

VIX from 2004 to the pres-

ent with ctul rel-time

mrket dt for which there

ws no need to historicll

reconstruct nthing.

The strnger in the group is

dt set #3. This includes

VIX dt (closing prices

onl) tht is subset of the

VIX dt in dt set #1 nd

dt set #2. It lso includes

dt for eight other indi-

ces. One of these eight is

the originl VIX (ticker

VXO) dt tht ws used

to clculte the VIX from

its lunch in 1993 to the

chnge in clcultion meth-

odolog in 2003.

[This post on the Histor

of the VIX nd VXO might

help with some bckground

informtion.]

These re three dt

sets ou referenced:

1. VIX: 19902003

2. VIX: 2004present

3. Nine tickers, including

VIX nd: 19862011

For our circumstnces,

m suggestion would be

to ppend dt set #2 todt set #1 to get the most

complete record of VIX his-

toricl dt. Going forwrd,

the onl dt set ou need

to concern ourself for

future dt points is #2.

Bill

Ask the

pertsThe Expiring Monthly Editors
http://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixarchive.xlshttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixarchive.xlshttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixarchive.xlshttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixarchive.xlshttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixcurrent.csvhttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixcurrent.csvhttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixcurrent.csvhttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixcurrent.csvhttp://www.cboe.com/micro/buywrite/dailypricehistory.xlshttp://www.cboe.com/micro/buywrite/dailypricehistory.xlshttp://www.cboe.com/micro/buywrite/dailypricehistory.xlshttp://vixandmore.blogspot.com/2008/10/vxo-chart-from-1987-1988-and.htmlhttp://vixandmore.blogspot.com/2008/10/vxo-chart-from-1987-1988-and.htmlhttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixarchive.xlshttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixcurrent.csvhttp://www.cboe.com/micro/buywrite/dailypricehistory.xlshttp://www.cboe.com/micro/buywrite/dailypricehistory.xlshttp://www.cboe.com/micro/buywrite/dailypricehistory.xlshttp://www.cboe.com/micro/buywrite/dailypricehistory.xlshttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixcurrent.csvhttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixarchive.xlshttp://vixandmore.blogspot.com/2008/10/vxo-chart-from-1987-1988-and.htmlhttp://vixandmore.blogspot.com/2008/10/vxo-chart-from-1987-1988-and.htmlhttp://www.cboe.com/micro/buywrite/dailypricehistory.xlshttp://www.cboe.com/micro/buywrite/dailypricehistory.xlshttp://www.cboe.com/micro/buywrite/dailypricehistory.xlshttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixcurrent.csvhttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixcurrent.csvhttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixcurrent.csvhttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixcurrent.csvhttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixarchive.xlshttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixarchive.xlshttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixarchive.xlshttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixarchive.xls


6/24


Ask the Xperts (continued)

Q: What is the best set-up

for a trading oce?

Jon

A: While ever trder is

dierent, I would personll

set up the following things:

super fst computer

nd internet line. If one

wnts to rell be pro,

get business clss cble

nd spend lot of mone

on fst CPU. In the long

run, it will sve ou lot

of mone. Get comfort-

ble chir, ou will be in it

lot, so dont skimp here.

Do not get desk with

lot of drwers, this is not

our home oce, this is

trding spcethe re

ou trde in should hve

little to no non-trding

things round it. Get sev-

erl screens, one for ever

piece of trding softwre

ou use, nd then t lest

one extr for the miscel-

lneous work one might

do like surng the web

for informtion, or tping.

Finll, get TV, but do not

wtch the nncil news

networks during trding

hours; I dont cre if its the

Price is Right or ESPN, but

do not hve the nncil

networks running, the will

serve to ll our hed with

bd ides. Finll, think

bout hving smll weight

ling round the oce,

even if its onl 23 pounds.

When ou re thinking,

bored, or bsicll n-

thing, grb the weight nd

do rm curls or triceps curls

. . . our mte will thnk

ou lter becuse our

rms will look wesome

surprisingl quickl. Notice,

no fridge, no keggertor,

no snck shop. If ou must

hve beverge mchinein the oce mke it cof-

fee mker.

Mrk
http://www.condoroptions.com/


7/24


Managing the

Short Time SpreadAndrew Giovinazzi

themarketsgot doublewhmm in the middle of M. First,

the debt reduction greement for

Greece ws promptl thrown out the

window when the Greeks could not

form government to bide b the

greement lred in plce. actull,

I thought to mself, Does tht men

the owe the bond holders the full

mount gin? Second, JP Morgn lost

some mone on trde, big trde.

The events together drove the SPX

down round 60 hndles nd the VIX

up to 25 on the close Frid the 18th.

It looks like no rll into the summer

nd ros equit mrket prior to the

elections. Wht looks likel is tht the

Greek voters will hve new elections

fter June Expirtion nd JP Morgn

will hve to swet out their big posi-

tions until mid-December where the

will hve to trde the roll of the cen-

tur. Tht brings me to the trde ques-

tion for this column. Is the short time

spred right for wht is going on in the

mcro world?

Lets tke some of the coverge on

JPM. It ws reported in The Wall Street

Journal tht JPM hd vrition of

short time spred on. Essentill the

bnk is long erlier-dted CDS index

contrcts in December 2012 nd short

frther-dted contrcts in 2015. For

our column here the exct trdes re

not tht importnt (not m p/l fter ll)

but it is the structure of the trdes tht

re importnt.

Measuring Short Time Spread

Risk

The short time spred is just long

contrct in the front month nd short

contrct in the bck month. The thing

most retil trders will notice is tht

it tkes up lots of buing power. So

much so, tht the front month contrct

is lmost ignored in the BP clcul-

tion when trders hve to go mrgin

the position. Tht is the problem, if

the reported news bout JPM is to be

believed. The mrk-to-mrket cn

get ugl. Risk-wise, here is wht trd-

ers fce:

t

v. Implied voltilit cn go

up for ver long time before

it comes in gin. This directl

ects the veg component of the

trde. Generll speking the lon-

ger the term, the greter the risk

involved. JPM looks to hve con-

trcts out quite ws so the dil

mrks re ugl. But just s esil is

the risk premiums melt in the secu-rities due to reduced perception

in risk, ll the mone comes bck.

Weighted veg is the other

snek component here. The totl

risk veg shows up ne but s

the terms distnce expnds both

vegs cn move in opposite direc-

tions. This is the equivlent of hv-

ing the trders hed in vise like

in Casino nd hoping Joe Pesci will

hve some merc.

t . as the underling secu-

rit for the trde whips round nd

moves, the short time spred ctu-

ll strts to perform. The frther

the underling goes from the initil

entr point the better. Short time

spreds re perfect for underling

movement tht is about to hap-

pen in high voltilit environ-

ment. The trde is generll bd

t for movement tht hs lred

hppened.

t

. The dil chew from thet

erosion mkes underling move-

ment big prt of this position.

If the underling does not move

nd ll is still, or keeps to tight

rnge, the thet could swllow up

the dollrs from the bck month IV

implosion.

t

fat contracts. Risk mngers like

this prt becuse the trde cn-

not blow up on size underling

move. This is lso the reson the

trde cn slip under the risk rdr.

Is the short timespred right forwht is going on in

the mcro world?

(continued on page 24)


8/24


Are Bonds Telling the

VIX Next Move?Mark Sebastian

insurance, everytrder wntsit, but onl few products ctu-

ll provide it. Insurnce products

dont exctl oer the best returns,

but wht the do oer is sfet. S

wht ou will bout the stte of U.S.

debt; regrdless, the owner of bond

or note will receive the full vlue of

the bond or note when the tresur

expires. It is for this reson tht, in

times of pnic, we see bonds rll to

extreme levels. another insurnce

product is S&P voltilit. When the

mrket is exploding, be it puts on the

phsicl SPX or options on VIX, the

prices of these products skrocket.

Becuse of this, there is generll

correltion of prices between the

price of the 30-er future nd the VIX,

which keeps the spred between the

two t somewht consistent level.

Similrl, tht reltionship holds true

in TLT. While the bond future is the

preferred method for trding U.S. debt

for institutionl trders, we re going

to stud the reltionship of TLT to

VIX, becuse of the continuit of price

tht doesnt exctl exist between

the futures. The bsis of futures from

contrct to futures contrct throws o

pricing just enough tht this doesnt

grph s netl. Tht sid, I think it

would behoove n serious trder to

follow up the results of our stud with

look t the reltionship between

the ZB futures contrct nd the VX

futures contrct. Tht would produce

potentill trdble pproch to swp-

ping ZB futures or options ginst VX

futures or options.

Since TLT ws rst listed, the Bond

ETF hs hd n ll time low price of

just over $81.00 shre nd hd

high price of just over $124.00 shre.

The ETF ps dividend bsed on the

ield of its bonds rther thn storing

the returns; thus the price is lmost

exclusivel bsed on where the cur-

rent long term ields re priced. at

the $124 price, long term ields re

below 4. at its price of $81 in 2003,

long term ields were MUCH greter.

as we stted bove, generll spek-

ing, the price of this product moves up

with fer nd down with clm (t lest

since the Fed begn using rtes to tr

to x the econom).

The VIX, or fer

index, represents the

cost of insuring port-

folio t n given time

using SPX options. In

times when the mr-

ket is in turmoil, the

VIX will tpicll be

hitting its pek. Over

the lst 10 ers, tht time cme dur-

ing the 2008 nncil crisis. The VIX

touched high of lmost 80; it hit its

low in times where mn thought ll

ws well. The index trded below 10

intrd in Februr 2007 before set-

tling t low just bove 10.00.

On their own, the VIX nd TLT

ech point towrd wht is hppen-

ing in the mrketplce t n given

time. It would mke sense tht the

spred between VIX nd TLT is some-

wht men reverting. Upon n opticl

scn, I noticed tht there ws direct

reltionship. a student of mine, Sm

Hrris, took m opticl observtion

nd sent me 10-er chrt of the

price of TLT minus the price of VIX. The

results produced ver cler pttern

nd distribution.

In Figure 1, we cn clerl see tht

there hs been nturl men in the

reltionship of TLT to VIX t round

7080. This mkes sense, s when TLT

Figure 1 TLTVIX

On their own, the VIX nd TLT

ech point towrd wht ishppening in the mrketplcet n given time.


9/24


is t low price, so is VIX, for instnce

in 2007. In Feb 2007, when the VIX hit

its ll time low, TLT ws lso trding

ner its ll time low. This produced

price right round 70. Even in 2008, s

the nncil crisis unfolded, we do not

see mjor string of the reltionship

of TLT to VIX. While the VIX exploded

to over 50 nd sted there for some

time, TLT trded into the low 120s,

keeping the spred close to 70.

In fct, the reltionship is lmost

lws round 70 to 80. Sm put

together nother chrt showing where

the distribution of prices lnd.

In Figure 2, one cn see tht the

overwhelming mjorit of the time, the

price lnded in between 70 nd 80.

Figure 3 shows 3D version of Figure 2

with some dtes.

Interestingl, usull when there

ws pnic, the spred between the

two drops to ner 60 before mov-

ing bck into the 70s. We sw this

when the 2008 crisis hppened. We

lso sw the spred drop in the 2010

sh crsh, nd the spred lso fell in

august hed of Greece.

More subtl though, if one studies

the grph one might notice tht, while

initill on VIX pop the spred drops

in crisis, leding into the VIX pop,

there is subtle increse in the spred.

This is usull from the low 70s out to

the upper 70s.

This is wht mkes wht the

mrket is currentl experiencing so

stunning nd hrd to trde. The cur-

rent TLT is priced t complete pnic

levels, while VIX is onl priced t

elevted levels. This is producing

pricing spred tht is trding over 100

rights s I write this rticle. 100 is

level tht ws completel unherd

of, level tht hd never legitimtel

trded until the lst few months of

2011 nd into 2012. Essentill, while

the VIX cme o from its august of

2011 levels, bonds never esed ver

much. Even s the TLT hit its recent

lows few weeks go, the spred ws

in the 90s. Things hve gotten little

more drmtic over the lst few weeks

while the VIX hs rllied from 17-ish

to touching 25; the rll in TLT hs

pushed the spred between VIX nd

TLT to ll time highs.

Wh?

While one might point to the culprit

being opertion twist, nd I m certin

tht TWIST hs not helped, I would

point to nother culprit out here: Fixed

income still believes tht there is

mjor event bout to hppen, even

if the equit mrkets do not.

Here is the scr prt. If the

spred is now over 100, wht

tpe of VIX spike is it going to

tke to bring this spred bck

to norml?

M thoughts: I hve hrd

time seeing rtes go to 3%. I

think there is n es trde

for the pickings right now, nd

I would/m selling cll spreds

on TLT, nd t the sme time,

I m buing VIX cll spreds.

If one ws so inclined, one

could lso consider selling TLT

buing VIX, nd buing S&P

futures. I would obviousl dollr-weight

it, but I would end up owning twice s

much VIX. Bsicll, I would sell the

expensive insurnce nd bu the chep

insurnce. EM

Are Bonds Telling the VIX Next Move? (continued)

Figure 2 TLTVIX Histogram

Figure 3 VIX vs. TLT Price Frequency


10/24


Risk or Uncertainty: Explaining the

Variance PremiumJared Woodard

inlastmonthscolumn,I explined some of the bck-

ground thinking behind the pper,

ambiguit aversion nd Vrince

Premium, which rgues tht

the vrince premium in options

prices cn be better explined in

terms of mbiguit rther thn

risk. I explined the dierence

between risk nd uncertint

in terms of the known rnge of

possible outcomes: risk situ-

tion is one in which the rnge of

possible outcomes is known to

be nite, while uncertint con-

fronts us with n unknown set of

possibilities.

The uthors of this pper

developed model designed to

test whether investor version

to mbiguit (i.e. uncertint)

provides better explntion of

the vrince risk premium thn con-

ventionl stochstic voltilit-bsed

models.

The results re promising. Recll

tht the existence nd especill the

size of the vrince risk premium is

not something tht cn be explined

b trditionl, consumption-bsed

economic models. B contrst, the

uthors nd tht the mbiguit ver-

sion model explins bout 96 per-

cent of the mrket-implied vrince

premium. Risk, i.e. stochstic vol-

tilit, explins onl bout 4 percent

of the premium. another interesting

result is tht the mbiguit version

model reproduces chnges in expect-

tions coinciding with mjor economic

swings, recessions, etc. Finll, the

model is lso tested for its relevnce

to the equit risk premium, tht is,

the return chieved bove the risk-

free rte (usull, U.S. Tresuries)

in exchnge for holding risk stocks.

Over the period 18902009, the equit

risk premium ws observed t 5.74%;

the mbiguit model produced lmost

exctl tht gure, while lso produc-

ing close estimte of the voltilit of

the equit premium (17% vs. 18.8%

observed), something the stndrd

model ws not ble to do.

One reson I pprecite the contri-

bution of this pper is tht it ccords

so well with our intuitions bout eco-

nomic ccles nd investor behvior.

Previous models hve ccounted

for observed vrince premi b

reling, not just on the ssump-

tion tht voltilit is stochstic

(rndom), but tht the voltilit

of voltilit is lso stochstic. This

rubs ginst the grin of wht

we see in the mrkets: while the

cuses of voltilit (nd of vol-

tile voltilit) re not lws es-

il discerned nd re never esil

nticipted, the re neverthe-

less cuses. Voltilit is not cre-

ted ex nihilo.

One of the implictions of this

model tht m be of interest to

trders is tht chnges in inves-

tor expecttions fter shift in

regimes, e.g. from booming to

busted econom, re likel to

persist for some time. Becuse

people hte rel uncertint, the

best time for trders to tke dvn-

tge of the vrince risk premium is

likel fter the onset of recession or

depression. This will not be shocking

news to experienced trders; however

being n option seller fter the onset

of recession is not, pschologicll,

lws so es.

The results of the pper re strik-

ing, but I wnt to rise one cution-

r g bout the model in light of the

risk/uncertint distinction. The dis-

tinctive feture of genuine uncertint

s discussed b Knight, Kenes (nd

before them, Hume on the problem of

induction), is tht in mn situtions

it is just impossible to know wht the

p a r t 2

(continued on page 24)
http://www.expiringmonthly.com/risk-or-uncertainty-explaining-the-variance-premium.htmlhttp://ssrn.com/abstract=2023765http://ssrn.com/abstract=2023765http://ssrn.com/abstract=2023765http://ssrn.com/abstract=2023765http://www.expiringmonthly.com/risk-or-uncertainty-explaining-the-variance-premium.html


11/24


M O N T H LY F E AT U R E

by Bill Luby


12/24


The Early Years: Expansion by Geography and

Underlying Index

In the beginning, there ws the VIXnd for the most prt

investors were oblivious or indierent to n index tht me-

sured the mrkets expecttions of future implied voltilit.

When the VIX ws lunched, CNBC ws still in its infnc,

the Mosic browser hd not been relesed, nd the generl

publics inftution with the stock mrket ws still severl

ers w. For the most prt, investors onl checked their

portfolios when the received brokerge sttement in the

mil t the end of ech month.

Of course, the nncil mrkets looked lot dierent

in 1993 thn the do now. at the time the VIX ws creted,

the S&P 100 Index (OEX) ccounted for bout 75% of ll

index options trdes (compred to just 16% for the S&P 500

index), so it ws nturl tht the VIX ws linked to the OEX.

Over time, the OEX begn to be displced b the S&P 500

index (SPX) nd the VIX broke from its moorings nd slowl

drifted w from the center of the equit index universe.

While the VIX hd no domestic competitors, it ws not

long before its rst interntionl peer ppered on the

scene. In December 1994, the Germn Futures nd Options

exchnge lunched the VDaX, bsed on the Germn equit

index, DaX, which consists of 30 lrge cpitliztion Germn

compnies trding on the Frnkfurt Stock Exchnge.

Interestingl, the VDaX did not follow the CBOEs VIX cl-

cultion methodolog. In fct, in its originl form, the VDaX

used the Blck-Scholes model nd focused on t-the-mone

options to generte 45-d estimte of implied voltilit

for the DaX.

Competition in the domestic voltilit index spce did

not rise until 2001nd once gin it ws the CBOE tht

ws behind the new index. When it ws lunched in Jnur

2001, the CBOE NaSDaQ-100 Voltilit Index (VXN) ws

rgubl better mesure of mrket voltilit thn the VIX.

The Vixen ws born in the middle of the tech meltdown,

t time when smll cp nd technolog stocks were led-

ing the mrket down nd the S&P 100 ws reltivel stble

b comprison. For the rst four months of 2002, the VXN

verged bout double the voltilit recorded b the VXO.

Even s the two indices strted to converge, in June 2002,

the VXN ws s high s 66.19, while the VXO never mde it

n higher thn 35.99. as technolog stocks continued to

fll nd drg the broder mrkets down with them, the VXN

provided more pointed brometer of the voltilit tht ws

rvging the mrkets during the dot com bust.

Lunched within 24 hours of ech other, the CBOEs VXN

nd the americn Stock Exchnges QQV (which ws bsed

on QQQ, the populr ETF for the NaSDaQ-100) hinted t the

possibilit of voltilit products rms rce between the CBOE

nd the aMEX. This never cme to fruition, s the CBOE out-

nked the aMEX nd soon cme to dominte the voltilit

index mrket. Tht domintion begn when the CBOE revo-

lutionized the concept of voltilit indices in 2003.

Rebuilding the Foundation in 2003

The two issues tht most hmpered the growth nd develop

ment of the VIX were:

1. the link to n underling index tht ws declining in

importnce; nd

2. clcultion methodolog tht focused onl on ner-

the-mone strikes

The CBOE remedied these shortcomings in September

2003, when the mde two criticl chnges to the VIX, sub-

stituting the SPX for the OEX, nd expnding the rnge of

strikes involved in the clcultion to include ll SPX options

quoted with non-zero bid prices. The net result of these

modictions ws to tie the VIX bck into the most impor-

tnt benchmrk equit index nd to mke the VIX clcul-

tion reect the full rnge of trdble SPX options in such

mnner tht the skew of the out-of-the mone SPX strikes

ws included in VIX clcultion.

The reformultion of the VIX clcultion methodolog

ws joint eort between the CBOE nd Goldmn Schs.

Not surprisingl, one of the outcomes of the reformultion

of the VIX ws tht it becme more useful to institutionl

investors, s the new VIX clcultion methodolog mde

the VIX conform more closel to institutionl prctices nd

specicll mde the VIX n pproximtion for the vrince

The Expanding Volatility Megaplex (continued)


13/24


swp rte tht is included in mn institutionl derivtives

products.

The CBOE indicted tht not onl were the interested

in modifing the VIX to provide more precise nd robust

mesure of expected mrket voltilit, but the were lso

explicit in stting tht one of the gols of reformulting the

VIX ws to crete vible underling index for trdble

voltilit products. Following tht line of thinking, the CBOE

lunched VIX futures in Mrch 2004 nd dded VIX options

in Februr 2006.

Expanding the Volatility Universe: 20052008

Following the lunch of VIX futures, the CBOE embrked

upon n ggressive cmpign to expnd their voltilit

index frnchise, rst b expnding the bse of the underl-

ing equit indices, then b expnding the time horizon for

the voltilit clcultion nd nll b moving beond equi-

ties into commodities nd currenc.

The rst step in this expnsion ws to roll out voltilit

indices for some of the mjor mrket indices. In M 2005,

the CBOE lunched VXD, bsed on the Dow Jones Industril

averge nd in M 2006, RVXwhich is bsed on the

Russell 2000 indexws dded to the mix.

The CBOE then chrged o in completel dierent

direction nd in November 2007 lunched the CBOE S&P

500 3-Month Voltilit Index (VXV). VXV is identicl to the

VIX in ever respect except tht it looks forwrd 93 ds,

compred to the 30-d window for the VIX.

The following er, however, mrked the biggest lep for

the CBOEs voltilit index expnsion strteg. In Jul 2008,

with West Texs Intermedite crude oil trding in the $140

per brrel rnge, the CBOE lunched the CBOE Crude Oil ETF

Voltilit Index (OVX). This voltilit index is bsed on the

United Sttes Oil Fund ETF (USO) nd ws dubbed the Oil

VIX b the CBOE right from the initil press releses. The

following month, the CBOE dded the Gold VIX nd the

Euro VIX to the stble. The former, which goes under the

ticker GVZ, is bsed on the populr gold SPDR Gold Shres

ETF, GLD; the ltter, whose ticker is EVZ, is bsed upon the

CurrencShres Euro Trust ETF, FXE.

Whether b luck or design, these new voltilit indices

just mnged to get out of the gte before the nncil cri-

sis of 2008 struck in ll its fur, leving dozens of new vol-

tilit records in its wke.

VIX Goes Mainstream During the Financial Crisis

of 2008

While voltilit ws growing in importnce nd notoriet prior

to the 2008 nncil crisis, it ws the crisis tht ctpulted the

VIX onto the center stge. as stocks plummeted nd investor

nxiet spiked cross the globe, the VIX cemented its reput-

tion s Wll Streets fer guge. The VIX quote becme

xture on CNBC nd fodder for nlsts from ll corners of the

medi who were seeking mens b which to evlute the

degree of uncertint nd pnic in the nncil mrkets.

With the incresed ttention being pid to the VIX, the

trding volumes for VIX futures nd options surged, s hedg-

ers nd specultors ocked to products tht demonstrted

convexit b being showing more dnmic upside moves

nd muted downside moves. This convexit ws prticulrl

ttrctive to institutionl investors who sought investments

with strong risk mngement prole.

For the most prt, retil investors continued to see the

VIX s more of mrket indictor during the nncil crisis

thn suite of products which could esil be trded. Tht

ll chnged in erl 2009 with the rst VIX exchnge-trded

products.

The VIX Exchange-Traded Products Revolution:

2009Present

Brcls introduced the rst VIX two exchnge-trded notes

(VXX nd VXZ) to ver little fnfre in Jnur 2009. These

products were mde possible b the cretion of two voltil-

it strteg indices b S&P Indices tht were developed with

n ee towrd VIX futures strtegies tht could be trnslted

into exchnge-trded products: the S&P 500 VIX Short-Term

Futures Index; nd the S&P 500 VIX Mid-Term Futures Index.

Over time, VXX nd VXZ grdull cptured the imgin-

tion of retil investors nd spwned grnd totl of more thn

thirt voltilit-bsed exchnge-trded products in the United



14/24


Sttes lone. The beut of these products is tht the mr-

ket mkers who sold them tpicll hedged these sles with

osetting positions in the VIX futures mrket. With VIX-bsed

ETPs frequentl trding in excess of 100 million shres per

d, the direct impct on VIX futures volumes cn be substn-

til. Through the end of april, for instnce, trding volumes in

VIX futures contrcts were up 68% over the previous er.

The Expanding Volatility Megaplex

In 2011, the CBOE took perhps its biggest gmble in

expnding the scope of voltilit indices, electing to list vol-

tilit indices on ve individul equit options in Jnur nd

six populr ETPs in Mrch, ll of which utilize the VIX clcu-

ltion methodolog. These VIX-stle indices trgeted some

of the most ctive nd sstemicll importnt individul

stocks, while the ETP indices focused on the dul themes of

emerging mrkets nd commodities. (See Figure 1 below for

the full list of single stock nd ETP-bsed voltilit indices.)

It ppers tht fter n pproch to blnketing the equit,

commodit nd currenc universe in serch of brod line

of diversied voltilit index products, the CBOE hs recentl

shifted to strteg in which trding volumes nd liquidit

re the min focus. In fct, in the cse of individul stocks

nd prticulrl ETPs, the list of new voltilit indices coin-

cides lmost perfectl with list of most ctive options. With

volume nd liquidit gols the driving force behind voltilit

index expnsion, this mkes it esier for the CBOE to focus

on the top volume issues nd pursue lterntive pproches

for res where demnd is still unproven, s ws the cse

with the Ntionl Stock Exchnge of Indi, which licensed the

VIX methodolog for the Indi VIX in 2008.

Bsed on recent success stories, the mgic formul for

voltilit indices seems to be centered upon creting prod-

uct pltform on which futures cn be built tht will ttrct

exchnge-trded products which include voltilit futures

in their portfolio. Here trnsctions in the ETP mrket re

hedged in the underling futures mrket, driving up volumes

nd tightening spreds in the futures mrket s prt of

virtuous ccle. In order to mke this hppen, criticl link

in the process hs been for the S&P Index group to crete

futures-bsed indices tht trget xed mtu-

rit nd utilize sttic nd sometimes dnmic

lloctions mong the holdings of the index.

To some extent, one cn look t where

futures (nd options) hve been lunched to

get sense of which res the CBOE believes

is most promising. at present, VIX futures

ccount for pproximtel 99% of ll vol-

ume on the CBOE Futures Exchnge (CFE),

where the voltilit index futures contrcts

re trded. The second most ctivel trded

futures contrct t the CFE is bsed on the

CBOE Emerging Mrket Voltilit Index, VXEEM.

The CBOE Brzil ETF Voltilit Index (VXEWZ)

nd the CBOE Crude Oil ETF Voltilit Index

(OVX) hve lso seen some investor interest

s of lte, but doption hs been slow in both

instnces.

In recent news, the CFE nnounced on

M 17 tht it plns to lunch trding on the


Figure 1 The Evolution Volatility Indices

VIXandMore


15/24


CBOE NaSDaQ-100 Voltilit Index futures contrct begin-

ning on Wednesd, M 23, pending regultor pprovl.

Bsed on VXN, these futures give the CBOE the more expo-

sure to the voltilit component of the red-hot technolog

sector, where the likes of apple, Fcebook nd Google hve

been ttrcting gret del of investor ttention s of lte.

Conclusion

From its humble origins, the VIX hs grown to become

dominnt force in the futures nd options spce. Recentl,

the ddition of VIX-bsed ETPs hs extended the VIX product

pltform nd chnneled new source of volume into the VIX

futures mrkets.

Up to this point, the CBOE hs hd dicult replict-

ing the success of the VIX in other voltilit indices, though

eorts hve been mde to extend the voltilit pltform

cross other mjor mrket equit indices, commodities, cur-

renc, individul stocks nd vriet of exchnge-trded

products. I think it is sfe to s tht the CBOE is intent on

tring to crete multi-dimensionl voltilit pltform, ide-

ll one tht spns sset clsses nd includes brod-bsed

indices, ETP sector nd geogrphicl groupings, s well s

individul stocks.

The relit is tht n product tht hs options ssoci-

ted with it hs implied voltilities tht cn be esil clcu-

lted. Provided there is sucient liquidit, n optionble

securit could esil hve multiple dt strems ssoci-

ted with it. The obvious ones, of course, re the price nd

volume of the underling. With options comes n dditionl

set of prices nd volumes, s well s open interest. There is

no reson wh some sort of men implied voltilit clcul-

tion cnnot be ssocited with the underling too, so tht

ever optionble sset lso hs its own VIX-stle voltilit

clcultion.

The rel question revolves round wht tpe of demnd

there is for futures nd exchnge-trded products bsed on

voltilit indices other thn the VIX.

While the new voltilit indices m be boon to options

trders who like to trde voltilit, the demnd for voltilit

indices on ech nd ever optionble stock, ETP, index, com

modit, etc. is lrgel unproven.

The big wild crd in this scenrio is the emergence

of ETPs nd the bilit of the voltilit index futures nd

relted ETPs to reinforce ech other in virtuous ccle tht

increses volumes nd keeps bid-sk spreds to minimum.

The VIX ETP spce hs proven to be irresistible to hedge

funds nd individul investors using short-term trding strt-

egies. With even greter exposure to voltilit, the emerging

mrkets voltilit index VXEEM nd the VXEM futures should

be n excellent test of the expnsion potentil of the voltil-

it index product pltform.

Looking pst VXEEM, there is lso the potentil for

success with VXaPL, the apple StockVIX. The other

re where potentil interest in voltilit indices remins

untpped is the nncil sector. Here it is es to imgine

voltilit indices bsed on XLF, the populr ETP. Voltilit

indices re lso possible on individul stocks such s

JPMorgn Chse, Bnk of americ nd Citigroup.

Voltilit indices hve been n unqulied success s

mrket indictors nd to lesser extent s product pltforms.

The recent explosion in voltilit indices mrks criticl new

stge in the development of these indices nd renewed

eort to replicte the VIX product pltform cross other vol-

tilit indices. So fr investors hve shown limited ppetite

for the new products, but if exchnge-trded products linked

to voltilit index futures cn ttrct the interest of investors,

it m usher in n even lrger voltilit megplex in which

the VIX is but one of mn product pltforms. EM

f r

Comprtive Implied nd Relized Index Voltilit,Expiring

Monthly, april 2012.

Trding the Expnding VIX Products Spce, Expiring Monthly,

September 2011.

VIX Convexit,Expiring Monthly, June 2011.

Evluting Voltilit across asset Clsses,Expiring Monthly,

Mrch 2011.

http://www.expiringmonthly.com/comparative-implied-and-realized-index-volatility.htmlhttp://www.expiringmonthly.com/trading-the-expanding-vix-products-space.htmlhttp://www.expiringmonthly.com/vix-convexity.htmlhttp://www.expiringmonthly.com/evaluating-volatility-across-asset-classes.htmlhttp://www.expiringmonthly.com/evaluating-volatility-across-asset-classes.htmlhttp://www.expiringmonthly.com/vix-convexity.htmlhttp://www.expiringmonthly.com/trading-the-expanding-vix-products-space.htmlhttp://www.expiringmonthly.com/comparative-implied-and-realized-index-volatility.html


16/24


Expiring Monthly Interview with

Mark SebastianJared Woodard

You know Mark Sebastian as one of

the co-founders and editors of Expiring

Monthly, but he wears many other hats,

too. He runs a successful mentoring

and education company called Option

Pit, consults as a risk manager for a

hedge fund, writes for The Streets

Options Prots team, and has become

a sought-after media commentator

as well. I got the chance to ask Mark

about his own trading, his new book,

and some other topics that I hope you

will enjoy.

Jaed Woodad fo Expn

Monthly: How did you get started in

trading? Why options?

Mak Sebastan: In m junior er

of college, I ws intent on getting into

investment bnking nd ws inter-

viewing with Goldmn Schs, Ber

Sterns, etc. at the end of tht er,

professor pulled me side nd sked

me to tke new clss he ws strt-

ing: Finncil Derivtives. While this

m be semi-common course now

t colleges, it rell didnt exist on n

cmpus 11 ers go. The moment

we begn digging into options, I ws

hooked, nd I decided I wnted to be

trder. I ws hired b Group 1 Trding

into their Mrket Mker trining pro-

grm nd er lter, I ws on

bdge trding options in the GE pit on

the americn Stock Exchnge.

JW: One of things I like about Option

Pit is that you oer mentoring services

for traders at several dierent levels

not just the standard introduction to

options for novices. What kinds of

things can an experienced trader learn

at Option Pit?

MS: at Option Pit, we concentrte on

being ble to service n client tht

sees us. For the low end trder, tht

mens rell lerning to understnd

the mechnics of options. For high

end trder, the biggest nd most com-

mon filing is the inecient use of cp

itl. Mn trders tht hve portfolio

mrgin dont know how to use it prop-

erl. The use of PM should ctull

reduce risk for trdernot increse

riskbecuse it llows the trder to

full trde three-dimensionll: not

just verticll cross months, but the

bilit to trde the months bck nd

forth ginst ech other. We lso oer

risk consulting services; in this service

we bsicll re hired to poke holes

in mone mnger, hedge fund, or

high net worth individuls trding

pproch. Our institutionl customers

love this service.

JW: A lot of options traders are just

leveraged technical analysts in dis-

guise, or long-term fundamental inves-

tors using options to control risk. What

sorts of research or analysis do you

rely on to create an edge in your own

trading?

MS: While trders need to hve t

lest mild knowledge of technicl nl-

sis, we onl rell look t it becuse

other trders re looking t it. The

technicls we look t for our option

trdes re lmost exclusive voltilit

nlsis. We stud where implied vol-

i n t e r V i e w
http://www.optionpit.com/home


17/24


tilities re reltive to relized

voltilities. We stud where

IVs re reltive to historicl

IVs nd where HVs re rel-

tive to historicl HVs. Bck to

our three dimensionl discus-

sion: studing voltilit, we

lso look t the term struc-

ture nd the reltionships of

voltilities cross months.

JW: What are your favorite

products to trade? Are there

any products you think trad-

ers should avoid?

MS: I love trding SPX,

SPXPM; I like the VIX ETNs

nd VIX options nd futures

themselves. I do not think

there is n product tht

retil trders should void.

In fct, I hve found tht if

there re people out there

telling retil trders to

void product, it is worth

reserching; guring out

wht is cusing problems

for retil trders nd then trding the

product. a misunderstood product is

protble product.

JW: What is it like being the risk man-

ager at a hedge fundwhat is an

average day like in that role? Does

that mean checking in periodically to

atten deltas, monitor position sizes,

check asset correlations, or what? How

do you manage the risk of an open-

ended position: say a trader has sold a

bunch of at the money straddles? How

do you estimate the risk in that situ-

ation: a VaR model, a hard dollar P/L

stop, or something else?

MS: Working risk for hedge fund

cn be fun nd cn lso be frustrting.

One of the issues I hve hd on the

risk consulting side is tht I dont hve

hrd control over risk in the w tht

mn hedge fund risk mngers do.

If I were to ocill work for hedge

fund I would need to be empowered t

level tht I could force trdes, some-

thing I hve been unble to do on the

consulting side. Tht sid, when

I m consulting I hve found tht

ech client is dierent. Some

need hrd dollr or percent levels

some need to hve price point

stopit vries. I like to combine

combintion of veg risk, gp risk

nd run risk when I m evlut-

ing the risk of position. The ke

to n position, in fund or in

personl ccount is to never let

position get out of hnd ndthis

is even more importntlws

be ble to keep trding.

JW: Drawing on your experience

mentoring other investors, what

are some topics or concepts that

tend to be harder to grasp? Are

there any areas where people are

more likely to make mistakes?

MS: The hrdest thing new trd-

ers nd to grsp is the pric-

ing model, snthetics, nd the

Greeks. Snthetics re hrd

becuse no one seems to wnt

to tech it. Despite the fct tht

it goes mostl ignored, n understnd-

ing of option snthetics remins the

ke to understnding options s

whole. One reson, I think, tht mn

trders lose so bdl in options is tht

the re never tught foundtionl

understnding of how options ctull

price: bd foundtion, bd everthing

else. To mke mtters worse, there re

mn progrms tht tech how the

Greeks work without teching how the

pricing model works. Without rm

understnding of the option pricing

Expiring Monthly Interview with Mark Sebastian (continued)

The OpTiOn Traders

hedge Funda Business FramewOrk FOr

Trading equiTy and index OpTiOns

Dennis A. Chen | MArk sebAstiAn

I :

I :
http://www.amazon.com/The-Option-Traders-Hedge-Fund/dp/0132823403/ref=sr_1_1?ie=UTF8&qid=1332259909&sr=8-1http://www.amazon.com/The-Option-Traders-Hedge-Fund/dp/0132823403/ref=sr_1_1?ie=UTF8&qid=1332259909&sr=8-1http://www.amazon.com/The-Option-Traders-Hedge-Fund/dp/0132823403/ref=sr_1_1?ie=UTF8&qid=1332259909&sr=8-1http://www.amazon.com/The-Option-Traders-Hedge-Fund/dp/0132823403/ref=sr_1_1?ie=UTF8&qid=1332259909&sr=8-1http://www.amazon.com/The-Option-Traders-Hedge-Fund/dp/0132823403/ref=sr_1_1?ie=UTF8&qid=1332259909&sr=8-1http://www.amazon.com/The-Option-Traders-Hedge-Fund/dp/0132823403/ref=sr_1_1?ie=UTF8&qid=1332259909&sr=8-1http://www.amazon.com/The-Option-Traders-Hedge-Fund/dp/0132823403/ref=sr_1_1?ie=UTF8&qid=1332259909&sr=8-1http://www.amazon.com/The-Option-Traders-Hedge-Fund/dp/0132823403/ref=sr_1_1?ie=UTF8&qid=1332259909&sr=8-1


18/24


model, there is rell no w to under-

stnd or evlute risk. This is becuse

the Greeks, the tools option trders

use, ctull come from the pricing

model. Too often retil trders rel on

grph tht is n output of pricing

model, without understnding tht

the risk grph cn chnge on them.

Without understnding snthetics nd

the model, risk grphs rell re

dngerous tool becuse trders think

the re fir evlution of risk, which

the re not.

JW: We see a lot of news these

days about changes at the options

exchanges: new exchanges open-

ing and being proposed, lawsuits over

products, the payment for order ow

controversy, etc. Why should an aver-

age investor care about any of that?

MS: The ke issue there is order ow.

In n rticle clled The Future of

Options Exchnges nd lso some-

thing tht I brie discuss in m new

book, The Option Traders Hedge Fund,

I point out wh order routing mtters. It

ll stems from Pment for Order Flow,

the prctice of ping brokers to route

orders to one exchnge or nother.

Generll speking, there re two

tpes of exchnge models, the tke

model nd the mke model. Tke

model exchnges p for orders tht

tke liquidit. Mke model exchnges

p for orders tht mke liquidit.

Needless to s, tht puts order rout-

ing in position to be in conict with

best execution prctices in their tru-

est sense of the word. Tke exchnges

tpicll hve ll of the liquidit while

mke exchnges hve ver little liquid-

it. yet, time nd time gin, becuse

of the contrdicting models we see

orders routed to exchnges with little

to no liquidit s brokers tried to get

pid on the mke.

JW: Tell us more about your forthcom-

ing book. How is this book dierent

from previous books on options?

MS: The book is dierent in tht it hs

little to nothing to do with the wht

of options nd lot to s bout the

how in options trding. Dennis nd I

spend lot of time tlking bout how

one needs to mnge their mone,

evlute risk, nd execute nd struc-

ture trdes. Our book is lmost like

hedge funds cookbook. It will give

trders ll the knowledge the need

in order to build serviceble option

trding business, long with the nec-

essr knowledge not to blow up their

ccount in the process. While no book

cn truthfull s tht it teches trd-

ers how to mke mone, our intent is

to come s close s humnl possible

to chieving this gol. Consider this

the rst hndbook for the option-inten-

sive hedge fund.

JW: Who is the intended audience?

MS: Our intended udience is trders

tht wnt to lern to think nd trde

like professionls. It is not begin-

ners book on n level nd is probbl

lmost n dvnced book. It is ment

to be follow up book to the Option

Voltilit nd Pricing books from

Ntenberg or McMilln. Wht I like

bout it, nd wh I think it hs brod

ppel, is tht lmost ever trder

retil, prop, or mone mnger

should lern to think bout options the

w professionl does.

JW: What are your favorite parts of

the book?

MS: The sections I rell like re the

prts tht involve mone mngement

We go into gret detil on how to mn-

ge mone t the portfolio level, nd

the individul trde level. I lso love

the lessons from the pit sections.

We took some of m old blogs from

Option Pit nd rewrote, updted, nd

pplied them to the frmework of the

book. Mn chpters led from lesson

to rel life experience tht hppened

s I ws trding or teching tht I

wrote bout.

JW: Thanks, Mark. EM

Expiring Monthly Interview with Mark Sebastian (continued)

The ke to n

position, in fund

or in personl

ccount is to neverlet positionget out of hndndthis is even

more importnt

lws be bleto keep trding.
http://www.expiringmonthly.com/vol1no10-dec-featurefutureofoptions.htmlhttp://www.expiringmonthly.com/vol1no10-dec-featurefutureofoptions.htmlhttp://www.expiringmonthly.com/vol1no10-dec-featurefutureofoptions.htmlhttp://www.expiringmonthly.com/vol1no10-dec-featurefutureofoptions.html


19/24


How Liquidity Providers

Price OptionsAndrew Giovinazzi

lastmonthicovered the tech-nolog chnges tht hve occurred on

the trding oors over the lst 20 ers

or so (t lest s long s I hve been

round in the option business). Most

of tht discussion revolved round the

pipes nd chnges going into the deliv-

er of informtion nd quotes. I think

it mkes sense to follow up tht piece

this month on how liquidit providers

price the options in the rst plce.

Pricing In the Old Days

Option pricing prior to the dvent of

Blck-Scholes ws bit more hurl

burl. The old timers I tlked to when

I strted in the lte 80s clled it, of

course, the good old ds. Things like

OTM options sting bid long pst their

chnce of nishing in the mone were

reltivel common. Vluing options b

pure feel nd rithmetic ws gret

exercise in snthetic reltionships. The

reversl/conversion, butter nd box

prett much ruled in the 70s nd 80s

s the min position mngement

vehicles. From the beginning, even

prior to Blck Scholes, the one thing

tht hs remined constnt ws the

need to estblish some tpe ofrelative

relationship for liquidity providers. The

dvent of the R/C, butter nd box

helped trders get grsp on the pric-

ing of one option reltive to the price

of nother. after ll, t expirtion those

reltionships will move to either prit

or expire worthless. B using snthetic

techniques trders could sell wht

the thought ws the expensive option

nd bid for the reltivel cheper

option nd be left with position with

reltivel little risk. This llowed some

liquidit to form in prticulr option

clss.

The mrket for clss of options,

lets s IBM (since there is some nos-

tlgi there) looks like this:

33 IBM Jul 205c

11 IBM Jul 210c

1IBM Jul 215c with IBM trdinground $197 in mid-M

The current bid on the IBM Jul

205/210/215 Cll Butter is bid the

liquidit providers w (buing on the

bid nd selling on the oer). The ide

for butter (bck then or tod) is

to bu the position for the smllest

debit possible ( credit is idel since

the position is virtull ssured of

mking mone). With ernings coming

out the IBM Jul 210c go bid to $2 lev-

ing the new mrkets this w:

33 IBM Jul 205c

22 IBM Jul 210c

1 IBM Jul 215c

Note how tht chnges the price of

the IBM Jul 205/210/215 Cll Butter

to credit the liquidit providers

w. Tht is wht trders cll edge.

Buing options in one plce nd sell-

ing them for quntible dvntge

is edge nd it is wht ll good trders

look for. The mrket mker or spe-

cilist cn now bid up the other cll

mrkets to keep putting on the posi-

tion. With this much edge nd willing

buers of the 210s, the LPs could step

up nd build lrge positions, provide

liquidit to other series nd crete n

orderl mrket. This whole process

would tke couple of seconds. a

ke prt for ll this working is pricing

round the current order ow. Tht is

the lever on which the mrkets move.

This leds to one of m trding rules:

The active strike drives the pricing.

Pricing Options In the Advent

of Auto Quote

With couple of rules in plce on rel-

tive vlue nd ctivit, pricing options

evolved to n exercise in mnging

the implied voltilities of the trded

series. auto Quote mde it es to just

plug in forwrd voltilit number into

the quote mchine nd out popped

whole clss of mrkets bsed on Blck

Scholes (or whichever model dpt-

tion the trding pit ws using). But the

sme problems of liquidit nd price

discover remined. Trders were

now posting mrkets on where the

thought the fair value of implied vola-

tility was trading at the time.

The new mrkets looked like

this from the liquidit providers

prospective:

3 (20%)3 (23%) IBM Jul 205c

2 (29%)2 (33%) IBM Jul 210c

(20%)1 (23%) IBM Jul 215c

Insted of the more rithmetic

intensive ctivit of pricing snthetics,

trders strted just trding the vol-

tilit. The public (tht mens ever-

one who is not n exchnge member)

f l o o r s t o r i e s


20/24


just sw the price quotes but trders

looked t pricing in n evolving light.

The sme customer in the 1970s p-

ing 2 for the IBM Jul 210 clls ws

now ping 33% Implied Voltilit.

Trders hd dierent tool to guge

customer interest since implied voltil-

it is esier to trck, remember nd

record reltive to underling moves in

the underling.

Trding positions got bit more

complex thn the reversl/conversion

crds of the old ds since new expo-

sures to risk were not necessril t

contcts or voltilit exposure. Mrket

positions mesured in exposure to

Veg (the chnge in n option price for

1-point chnge in voltilit) begn

to tke over s liquidit providers got

more grnulr in their pricing. Trding

for edge now ment selling higher IV

nd buing lower IV nd spreding

the risk o in the whole clss b dd-

ing positions in the outling months.

Pricing Options Now with the

Electronic Eye

Estblishing some reltive vlue is the

most importnt step in pricing options.

The dvent of full utomted mr-

ket mking tht exists tod tkes

ll of this to new degree nd speed.

Essentill think tht option pricing is

generted b computers tht re mn-

ged b people. The rules for nding

edge still ppl. If no edge exists in

the current pricing, the LPs move the

implied voltilities until the suppl nd

demnd curve come into equilibrium.

Wht hppens now is tht the shifts in

voltilit re ver fst nd ver erce

in generl. One of best ws to trde

this from the prop side is simpl just

witing until the mrkets get pushed

in prticulr direction nd then posi-

tion in n ctive nme. Looking for

edge now is more function of keep-

ing n ee out until pper hs strted

to stretch the mrkets bit.

Most professionl trding sstems

re now looking for pper in the con-

fb of the vrious exchnges. The re

set up with n electronic ee to scour

mrkets to lift smller order ow tht

ts the theoreticl vlue nd voltil-

it prole of tht prticulr liquidit

provider. Once sh of liquidit hits,

the sstems still hve to djust s the

reclibrte wht new edge looks

like. Trders now hve dierent ccess

speed nd pricing bilit but re still

looking for the sme thing the lws

hve, which is to nd reltive edge

in the mrket. Buing low nd selling

higher never goes out of stle but wit

to do it now is bit dierent. EM

How Liquidity Providers Price Options (continued)

Trders now hve dierent ccess,

speed nd pricing bilit but re stilllooking for the sme thing the lws

hve, which is to nd reltive edgein the mrket.
http://vixandmore.blogspot.com/


21/24


Gundlach on Apple and

Natural GasJared Woodard

inaspeechatthe New yorkycht Club in lte april 2012, well-

known fund mnger Je Gundlch

presented slide compring the price

of apple stock since 2009 with the

price of Google since 2004.

The comprison is ttention-grb-

bing, nd the recent hsteri bout

apple is fmilir when we think bout

the sentiment towrd Google in its

erl ds. But wht rell cught

everones ttention ws the comment

Gundlch mde next:

If I were one of these crz hedge

fund gus, with the slick hircuts nd

fnc shoes nd rcing stripe shirts,

the trde Id put on is 100-times-lev-

erged nturl gs long versus 100-

times short apple.

The reson for the comment, s

he explined in n interview severl

weeks lter, ws tht t the sme

time sell-side nlsts were tring to

out-do ech other with ever-higher

apple price trgets, other nlsts

were lso competing to see who would

be the rst to price nturl gs t

$0.00. There is trend-following, nd

then there is blind fith. We cn ctu-

ll quntif the unusul nture of the

nturl gs/apple reltionship: Figure 2

plots the log rtio of UNG/aaPL shres

since 2007.

Notice two things bout this chrt.

First, the log rtio is so smooth tht

liner regression gives us n R^2

vlue of 0.94. Second, t the time

Gundlch clled for this trde, the

reltionship hd swung to n historicl

extremenot just lower thn t n

f o l l o w t h a t t r a d e

FigurE 1 Google vs. Apple

FigurE 2 Log Ratio of UNG/AAPL Daily Closing Prices, 20072012


22/24


time in histor, but lso fr, fr below

the regression line. Wht sounded like

hlf-joking gmble turned out to be

ver resonble men reversion pl.

Not wnting to tke on the risk

or tie up the cpitl needed for

strightforwrd long UNG / short aaPL

position, on M 9th I put together

version of the sme position using

options. We bought the aaPL Jul

565/505 put verticl t net cost of

$20.15 nd bought the UNG Jul 17

clls for $1.82. 11 UNG clls were

bought for ever 1 aaPL put spred. at

the time of entr, the apple puts were

priced round 31% implied voltilit,

which ws bout verge compred

to the lst ers worth of observ-

tions. Nturl gs implied voltilit hd

lred jumped up fir mount, but

since the trde thesis clled for bot-

tom in gs prices, being long voltilit

ws the onl w to go.

Figure 3 shows our trde entr

nd how the reltionship hs fred

since then. The position hs obviousl

worked out well: the aaPL put spred

is bsicll t brek-even but the UNG

clls hve exploded higher long with

nturl gs prices. a 111 lloction

to the position (the smllest possible)

is up bout $775.

With bout 60 ds remining

until Jul expirtion, I m comfortble

holding onto the position bit longer

before rolling everthing into lter

ccle to void too much time dec.

The UNG clls re now lmost $2 in

the mone nd the long strike of our

aaPL puts is t the mone, so there

is still plent of juice left in this trde,

delt-wise.

I wnted to review this position

becuse its bsed more on sttis-

ticl reltionship nd on the fund-

mentls of the ssets rther thn the

pure voltilit nlsis tht we usu-

ll cover; I prefer the ltter, but hve

spent more time in the lst er look-

ing t fundmentl dt before mking

trdes. In the cse of nturl gs, the

scndl t Chespeke nd the suppl

relief hve voided wht could hve

been disstrous summer for nturl

gs prices. I like apple s much s the

next gu (I think I ws the onl kid in

m town growing up who hd n apple

IIGS), but the revivl-tent nture of the

stock rll nd ttendnt medi cover-

ge did wrrnt some skepticism.

The question tht remins is wht

to do in three or four weeks when it

comes time to roll the position. M

rst step will be to check in on the

rtio nd where it is in reltion to the

regression line. Bsed on the chrt t

Figure 2, complete reversion higher

would tke the log rtio to -3.20 or -3,

depending on time, which is where

it ws in lte Jnur. Thts quite

bit more upside potentil, even if we

ignore or den Gundlchs comment

tht this trde hs monster legs.

assuming the reversion higher con-

tinues, I will probbl keep some long

nturl gs exposure but strt trim-

ming the short apple position more

hevil. EM

Gundlach on Apple and Natural Gas (continued)

FigurE 3 Log Ratio of UNG/AAPL Daily Closing Prices, 20112012


23/24


The Education

BusinessMark Sebastian

earlierthismonthI wsquoted in piece for Bloomberg

Businessweek titled: americns Es

Mrks with Options Inspired b Powell

nd Bush. While I ws slightl mis-

quoted in the piece (I stted tht

bout 10% of ll those who tr to trde

options will bet bnk ccount, not

m own students), the misquote led

me to thinking bout how relistic we

ll re with our nnces. Writing for

this mgzine we hve t n given

time four of the best trders in the

business discussing options, et I cn

promise ou tht ech of us hs hd

losing ds, months, nd in m cse

losing ers (I hd terrible 2008). yet,

how often do we in the nncil press

tlk bout our big losers? I cn tell ou

this much, its rre . . . nd we re the

GOOD GUyS!! If the good gus re not

tlking bout their losers, then how in

the world is the newbie option trder

supposed to be ble to decipher the

good gus from the bd gus?

This leds me to the next big ide

I think could mke lot of sense for

mrketing to retil trders: pitch the

truth. This doesnt men tht the hon-

est gus hve to wlk round sing

He, everone, I m n idiot,

but mbe it might mke sense for

those of us good gus to write bout

the losers we hve s often s the win-

ners, even if there re fewer losers in

the bunch. Wh? Becuse it will be

possible to do something tht I hve

thus fr hd big problem estblish-

ing with potentil clients: relistic

expecttions.

The retil public hs totl lck of

wht is relistic expected return for

portfolio mnged b n individul

investor. Much of the blme lies on the

scumbgs in the rticle bove. The

use few tricks tht mke big returns

seem es.

The will often l out $10,000

portfolio nd show some sort of

phenomenl return. Wht theleve out is the risk involved in

the trde. The dont let the retil

trders know tht there is big dif-

ference between trding $10,000

portfolio nd $1,000,000 portfolio

on this pproch.

The lso leve out interd nd

intermonth swings. It is es to

show gret theoreticl return

when the trder simpl closes his

or her ees nd comes bck 30

ds lter. This leves out the men-

tl impct of wtching position.

Often, the time period of the trde

is selectivel chosen. I cn es-

il show none how to mke

lot of mone being short VXX or

long XIV s long s the time period

is November of lst er through

april of this er. If the time period

is the month of M in 2012, I mgoing to hve lot more trouble

showing gret return.

But the biggest lie is probbl in

the degree of dicult these rms

pitch. I went through er of trin-

ing before getting on bdge. Jred

nd Bill spent ers lerning this

business before the got rell good

t it. andrew ws trding before

there were puts so Im not sure

wht his stor is (kidding). The point

is tht we re ll ver experienced

t trding nd we still lose some-

times, nd certinl none of us re

oting 250% returns nnull, e

fter er (lthough I believe we ll

hve probbl hd n mzing er

here nd there). The truth is tht

trding is hrd, nd n sles pitch

tht ss nthing dierent is lie.

So wh strt posting our losers if

ll of the scumbgs pitch how es

it is to win? We cnt sve everone,

lets fce the fcts, some people re

stupid nd ment to be hd. It cn

esil hppen to none (heck, I hve

Theter Innovtion Stereo ling

round m storge re somewhere).

However, I believe tht most people

rent stupid; if the bulk of the hon-

est ones strt pointing out wht its

rell like out there, prett soon the

scumbgs re going to be gretl

wekened or stright up out of busi-

ness . . . good. EM

B a c k p a g e

The truth is thttrding is hrd,nd n sles

pitch tht ss

nthing dierent

is lie.
http://www.bloomberg.com/news/2012-05-02/americans-easy-marks-with-options-inspired-by-powell-and-bush.htmlhttp://www.bloomberg.com/news/2012-05-02/americans-easy-marks-with-options-inspired-by-powell-and-bush.htmlhttp://www.bloomberg.com/news/2012-05-02/americans-easy-marks-with-options-inspired-by-powell-and-bush.htmlhttp://www.bloomberg.com/news/2012-05-02/americans-easy-marks-with-options-inspired-by-powell-and-bush.htmlhttp://www.bloomberg.com/news/2012-05-02/americans-easy-marks-with-options-inspired-by-powell-and-bush.htmlhttp://www.bloomberg.com/news/2012-05-02/americans-easy-marks-with-options-inspired-by-powell-and-bush.html


24/24

Managing the Short Time Spread (continued from page 7)

Risk or Uncertainty: Explaining the Variance Premium (continued from page 10)

If the risk mnger looks t it from

the underling move perspective it

shows up s big positive.

Are the Conditions Right for a

Short Time Spread?

Where does this leve us right now in

the middle of M going into the June

ccle in the big indexes? While there

is some chop right now, IV is reltivel

high, but most likel will not be ble to

nnce the level through June expir-

tion. No Greek election news for the

June ccle mens possible test to lows

nd some downside but not rel col-

lpse since the mrket is still short

reson. at the sme time Greek elec-

tions re fter the June ccle so those

months will st elevted until the

Greeks decide their own fte. This

is not the recipe for the short time

spred becuse there is not enough

movement ner term with voltil-

it collpse, t lest not et. There re

other ws to fde this Greek Trged

but I dont think on M 22nd tht the

short time spred is the right pl. For

now I think JPM might gree. EM

rnge of outcomes might be. Its not

just tht we cnt predict the future;

its tht we cnt even tell where pos-

sibilit spce ends nd impossibilit

begins.

B developing model to mesure

investor version to uncertint, the

uthors m well hve found bet-

ter w of explining historicl mrket

prices. But, s with n quntittive

model, its vlue in the future will onl

ever be function of ever-chnging

investor ttitudes. as result, the

model itself is onl s stble s ggre-

gte investor pscholog. The mbi-

guit version model estimtes the

vrince risk premium bsed on

few fctors, the most importnt being

the dierence between the expec-

ttions bout booming econom

between n mbiguit-verse inves-

tor nd n investor who exhibits cls-

sicl expected-utilit behviors. Now,

we know how to estimte the ltter

expecttionthts just the CaPM, e-

cient mrkets orthodox tht hs been

tught in business schools for decdes.

How do we estimte the former, the

expecttions of mbiguit-verse inves-

tors? The uthors rel on n existing

model known s Epstein-Zin tht incor-

portes elstic consumption prefer-

ences tht vr over time. M worr is

tht, s the composition of the invest-

ing public chnges, preferences bout

consumption nd mbiguit re likel

to chnge, too. Wht if the economic

ccles of the next 30 ers dont look

nthing like the lst 30 ers? How

will the shift mong Bb Boomers

from equities to bonds ect the equit

nd vrince risk premi? These sorts

of long-term issues become more

importnt when our pricing model

mkes explicit ssumptions bout

investor preferences. In other words,

there is some genuine uncertint sur-

rounding the mbiguit model. EM

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