I had a student yesterday ask me why the VIX (S&P 500 Volatility Index) moves opposite the market, and how it is calculated.  I thought the answer might be interesting to others...

From: http://www.optiontradingpedia.com/vix.htm

So since the VIX is calculated as an average of the IV of many options, that explains why the VIX moves the opposite of the market (i.e. when the market goes down, IV tends to go up) – mostly because people are buying  lots of puts to hedge their positions – so when the demand for puts goes up, the market maker responds by increasing the price of puts (supply/demand curve) – thus the IV of the puts increase.

Well, many of you may have seen the announcement already, but if not, my latest news is that I've joined Dan Sheridan's mentoring team!   I've been a great fan of Dan's for some time now, and when Dan called and offered the chance to become part of the mentoring team, I certainly couldn't say no!

If you aren't familiar with Dan Sheridan, after more than 22 years in the pit of the CBOE, he created what I consider to be the best options mentoring program in the business.  You can read more about Dan and his mentoring program at www.sheridanmentoring.com.  You can also catch Dan on the CBOE's "Options Safari" at dan on cboe tv.

You can reach me at Sheridan Mentoring by email at jay@sheridanmentoring.com.

Every experienced option trader should know how to use the option greeks to evaluate their current positions as well as being able to do a "what-if?" analysis to determine what might happen to their positions given changes in price, time, or volatility.  In my experience, most newer traders (and some not-so-new ones) have not taken the time to really understand and memorize the basic, practical rules that affect their ability to analyze their trades.  Not only that, I've never seen a concise list of the characteristics I've found to be most important.

To that end, I've developed a list of what I consider to be the most essential rules and characteristics to remember about the greeks.  Nothing esoteric here, just practical information.

Within each category (greek) I've also listed the characteristics from most to least important, and sub-characteristics under each major characteristic as a sub-bullet.  (Tip: if you have trouble remembering the sub-bullets, just memorize the numbered items, since the sub-bullets follow intuitively from concept in the numbered items anyway.)

Delta

1. For each one point increase in the underlying price, the value of the delta is added to the value of the option.
   • Conversely, for each one point decrease in the price of the underlying, the value of delta is subtracted from the value of the option.
2. The delta of call options is always positive (0 to 100) and the delta of put options is always negative (0 to -100).
3. The delta of an at-the-money option is approximately .50 (calls) or -.50 (puts).
4. The delta of an option at expiration is either 0 or 100 (-100 for puts).

Gamma

1. For each one point increase in the underlying price, gamma is added to delta.
   • Conversely, for each one point decrease in the price of the underlying, the value of gamma is subtracted from delta.
2. For all positive theta positions, gamma is always negative.
   • Conversely, for all negative theta positions, gamma is always positive.
3. For out-of-the-money positions such as condors, gamma is generally small compared to delta and inconsequential, whereas gamma is generally larger and has bigger associated risk for at-the-money positions such as calendars.

Theta

1. For each day that passes, the value of theta is added to the value of the option.
2. Long option positions are theta negative (lose time value each day), while short option positions are theta positive (gain time value each day).
3. For longer term options, theta decay is slower, conversely shorter term options have faster theta decay.

Vega

1. For every 1% volatility increase in the underlying asset, the value of vega is added to the value of the option.
   • Conversely, for every 1% volatility decrease, the value of vega is subtracted from the value of the option.
2. The impact of volatility changes is greater for at-the-money options than it is for in- or out-of-the-money options.
3. The impact of volatility changes is greater for longer term options and less for shorter term options.
4. Changes in vega can have more impact (i.e. you should worry about it more) for multi-month spreads (calendars, diagonals) than for single-month spreads (verticals, condors).

Rho

1. For every 1% increase in interest rates, the value of an option increases percentage-wise by the value of rho.
   • For example, if the rho of an option is 2.5, and interest rates increase by 1% ,then the value of the option increases by 2.5%.
2. For two reasons, you can usually ignore rho for most practical purposes.  First, interest rates don't change that often, and second, for short term options, rho is small and doesn't have much effect.
3. Rho is more important for long term options such as LEAPs.

In my earlier blog on oil prices, I made the case that it was not supply and demand, but rather speculation and the weak dollar that were the primary drivers of the $147 oil price spike.  Despite Ben Bernanke's claim before congress to the contrary, new evidence has now emerged strongly supporting the case for speculation as a major factor.   In an article yesterday by David Cho of the Washington Post, A few speculators dominate the vast oil market,  it was reported that the Swiss energy company Vitol held as much as 11% of the total oil contracts open on the New York Mercantile Exchange in the July timeframe.  When the Commodity Futures Trading Commission studied Vitol's books, it found that "that the firm was in fact more of a speculator, holding oil contracts as a profit-making investment rather than a means of lining up the actual delivery of fuel", according to Cho's article.

You can learn more about the commodity market for oil on the NYMEX site here.  (Use the tabs and agree to NYMEX's agreement to see the data). As an example, here is the latest session overview for Light Sweet Crude Oil

Many traders wonder what spread width they should use for their Iron Condor trades.   For those not familiar with the terminology, "spread width" generally refers to the distance between the short strike and the long strike on one side of the trade.  For example, in the trade below, the spread width of the call spread is $10, because we are selling the 820 call and buying the 830 strike and the difference between the two strikes is $10.

Most iron condor traders I have encountered set the spread width of the trade without too much thought as to why they picked that width over another, or what the effect on the trade might be.

Most traders understand that the wider the spread width, the larger the overall margin requirement becomes, and ditto for the risk associated with the trade.  I suspect most traders just pick the closest strike above or below the short strike they sold, figuring that if they use the least width possible, they minimize margin requirements and risk.   However this is not always the best choice, and since we can easily determine the optimal spread width, let's do so and get every edge we can.

So how do we define "optimal"?

The chosen spread width affects two things: the risk and the credit.  And since credit / risk = ROI, and we are all interested in maximizing the return per dollar invested, it seems to me that the spread width with the best ROI would be considered "optimal".

Let's look at SEP 08 Call chain on the SPX from today for an example:

Assuming we are selling the 1370 strike with a .09 delta, and buying either the 1375, 1380 or 1385 strike, we can compare the ROI of the $5, $10, and $15 strike widths to see which one has the best ROI.  Let's run the numbers just using the Mark prices and see what we get:

For example, taking the Mark price of the 1370 strike ($2.675) and the 1375 strike ($1.975) and subtracting, we get a credit of $0.70 cents.  Using 10 contracts and $1.50 commissions, we calculate the ROI in the last column to be 15.5% for the $5 strike width.  In this case, the $5 width is clearly better than the $10 or $15 strike widths, since they have an ROI of only 9.2%*

Spreadsheet tool to help with analysis

In the case above, the narrowest width was the best, but this is not always the case.  For example, normally I find that the $10 spread has a better ROI on the SPX than the $5 spread.  (The price table above was captured when the market was closed, so I suspect the results even today will be different once the market opens).  Certainly, given the difference between a 15.5% and 9.2% ROI in this example, it certainly pays to do the calculations and see which spread width gives the best result.

I've put together a little spreadsheet to help you do the Spread Width Analysis.  The spreadsheet columns C (Spread) and D (Credit) should be updated with your own live examples, and the rest of the data is calculated for you.  Note that commissions can have a dramatic effect on this analysis as well, especially when trying to choose between trading say, the RUT vs the IWM.  In the spreadsheet, you can insert your particular commission structure at the top,  and the spreadsheet will consider commissions in the calculations as well.

Enjoy!

When the price of a barrel of oil was at $140 - $147 a couple of weeks ago, I was telling anyone who would listen that these prices represented a bubble, and oil would hit $100 again before ever climbing to the $200 that most analysts were predicting would be reality before the end of 2008.  Now with crude trading as low as $113 in the last week (a 23%+ drop from the peak), the $100 target is starting to be more believable. 

Now the media is finally starting to catch on (at least a little).  Bloomberg had an article this week predicting that prices would fall to $90 a barrel or lower in the next few weeks, and that OPEC would be cutting production in order to shore up prices.  Jon Markman even wrote an MSN Money article Could Oil Plunge to $65? discussing the predictions of one analyst that now believes that prices will go even lower.  Here's another Forget $100, Oil Will Plummet to $30 that makes a case for (are you ready?) oil at $30!  

While I don't think we'll get to $30 or even $65 soon, I do think we'll stabilize somewhere between $90 and $120 for a while.  The basis of my prediction was plain and simple fundamental economics.   We started in early February 2007 with prices around $55/barrel and by June 2008 we had a record $147/barrel.  That represents a 167% increase in just 16 months.  In order for that meteoric rise to be anything other than speculation, we would need to see one of two things: either supply dwindling or usage increasing at similar rates (or a combination of the two).  World-wide supply growth has been slowing recently, but certainly not getting smaller, and world-wide usage hasn't increased appreciably either - this information is readily available in many places. 

So we are left trying to find reasons other than supply and demand to account for the drastic increases.  One reason is that the value of the dollar, until recently, has been dropping against other currencies.  Because the United States is by far the largest user of oil products in the world*, the value of our currency has a major impact on the price of oil, since any drop in the value of the dollar causes imported goods to be relatively more expensive.  However, in the last few weeks, the dollar has been much stronger, and in fact posted it biggest gain against the British Pound in 37 years. 

The other factor causing oil to spike to $147 is simply speculation.  Ben Bernanke stated in his testimony to a Congressional committee a few weeks ago that the increase in oil prices was not likely caused by speculation since traders did not actually "take delivery" of the oil they traded.  While I usually agree with Mr. Bernanke, I couldn't disagree more in this case.  If traders buy, and others bid up the price and sell to other traders, the price will increase, regardless of whether they take delivery or not.  Bernanke's idea is a little like saying that speculative traders can't drive up the price of Apple stock because most of them don't "take delivery" of iPhones! 

Notice that using 2008 inflation adjusted dollars, oil has been mostly trading in a remarkably consistent $20-$35 range for fifty years, except for two major spikes that you see on the chart, one beginning in 1972 and the other in 2004.

Inflation Adjusted Oil Price Chart

Oil prices haven't yet reached the $147 apex in this April chart, but I'll bet that few will remember that oil was trading at the equivalent of $106.43 in 1979 before falling back to the $20 price range.  If it happened once, it can certainly happen again...

*The United States uses 20% of the world's oil, with China a distant second consuming 7%. Source: World Oil Producers and Consumers