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Using Vega

The strongest point of my last post, “Examine Changing IV in intra-day trading” was that IV loses about 10% of its highest value by 10:30am.

For example, if your option’s IV is 33% at 9:45am, it will fall by 3% down to 30% by 10:30am, or by lunch-time at latest.

The last post also mentioned vega as the amount of value your position gains or loses for a 1% change in IV.

Really, all you need to know is that the higher your IV is, and the higher your vega is, the more you will lose if you buy the option before 10:30am.

Here is a calculation you might find useful if you like math:

Let “L” = approximate value lost due to changing IV in the morning
Let “IV” = IV at 9:45am

L = IV * 0.1 * vega.

Examine changing IV in intra-day trading

The trading data for this topic is based on the June 15 GS trade you can see in an earlier post.

With 100 contracts, I spent $42,000 on this GS trade, purchasing the options at 33% IV. My position’s vega was $1,400, or 3.3%. What this means is that for every 1% change in IV, my position’s value would gain or lose the vega amount. I mention this to you so that you understand how to check your own exposure to implied volatility.

Looking at the picture, see the first bar that gapped up? It was the opening bar for the new day, and I bought my call option at the top of that bar, two minutes after the market opened. Four minutes (two bars) later, the position was at more than $5,000 profit, or more than 10%.

I wasn’t quick enough with the trigger, and failed to snap up the intermediate profit (so that I could buy again when the spike dropped off). It wasn’t for lack of effort – at this end of the market, I believe I was almost literally pumping the computer to try and get the order in

As you can see from the picture, one bar (two minutes) later, IV had dropped 1%, and the position had lost a corresponding $1,400 from the profit. Ten minutes (five bars) further on, the stock was at its high point for the day, but IV had dropped by 3%, and even though the stock price was so high, my position was at only just a little above break-even.

This illustrates the first point I wanted to make clear: IV drops between 9:30am and 10:30am. Therefore, if you buy an option before 10am, you must buy it with the intention of selling it before 10am! You have only a few minutes to get rid of the position. If you don’t, reducing IV will hurt your position for the rest of the day, until it picks up again in the afternoon. IV reaches its lowest point at lunch time and generally increases again into the afternoon.

If you’re buying an option with the intention to hold for the rest of the day, or overnight, never buy it before 10:30am. There are exceptions, of course, and we’ll examine the various cases below.

I would say that experience has shown me that in the hour from market open until 10:30am, IV drops about 10% of its highest value. For example, if IV is 50% at 9:45, it will drop 5% down to 45% by 10:30am, or by lunch-time.

Obviously, if your option has IV as low as 25%, you will see a fluctuation of only 2.5%. These estimates are fairly rough, of course … beginner traders should be trying to understand these principles, rather than trying to memorize the data

SIDE NOTE:

Why would you buy an option you want to hold for less than half an hour? Well, in a choppy market such as we have today, it’s very easy to make 10% in the mad morning rush of TV traders shouting “buy them all” at their brokers. Just use an expensive stock with an average daily range of more than $3, and make sure you’re buying into momentum. It only works in a choppy market – the period from 25 Nov 2005 until 10 May 2006 was NOT good for these types of trades. Beginners will have to build experience, and please remember, it doesn’t work unless the market is mad-house. If you really want to do this type of trading, it’s probably easier to do it after the lunch-hour. IV is more consistent, and the moves are a little stronger.

Goldmann Sachs, June 15, 14% profit in 5 hours

June 15th marked the biggest bull-run in a single day that I have ever seen. So I’m a little ashamed that I only managed 14% profit on this day. I’ll pull the trade apart, topic by topic below, with some more posts, but here are the pertinent facts:

9:32am –> Purchase July 145 Call @ $4.20
2:52pm –> Sell @ $4.80
Profit = 14%

A word on Fibbonacci

I think the key to FR is to remember … it’s for calculating RETRACEMENTS … that’s why they are called Fibbonacci Retracements.

“OK,” you say, “what does he mean by that?” Below, I’ll show you an example of a time to use FR and a time not to.

Technically, a retracement is a short-term pull-back from a stock’s general trend. Take a look at this chart for a good example where the SPX has retraced, or pulled back, from its downward trend, all the way up to the 50% FR, before continuing downward in the last couple of days.

Yes, you did see right … I drew the FR lines using the highest close and the lowest close. I find it’s often more accurate to draw FRs using closes instead of absolute highs and lows. While trading, I sometimes draw the FRs using both, and just use whatever feels best.

Don’t use FR if the stock is not retracing.

Most typically, I use FR to confirm my suspicions that a stock has finished a minor retracement (rounding out) and is about to resume its original trend.

For example, if you look at the SPX chart above, you will see that the SPX tested the 50% FR on 2 June, and I entered the CRM trade on 5 June. On 5 June, I looked back on the FR to help confirm that the SPX had finished retracing.

Mirriam MacWilliams uses the FR a little differently. Had the SPX closed above (broken through) the 50% FR, on 2 June, next day she might have opened bullish trades targeting the next FR upwards. In this case, though, there was not much room to move, so she would have probably done nothing.

Here’s a good example of a time not to use FR … Yahoo was trending downward for some time and retraced. The FRs could be used to calculate its first retracement. From the time marked on the chart, YHOO has not been trending anywhere, or retracing from anywhere, so there has been no reason to use FR in calculating short-term support / resistance.

In fact, right now, YHOO is really waiting for direction in one way or another. It’s not retracing, and that’s why we wouldn’t use FR with it at the moment.

Downside learning slide

CRM gave us (me, at least) a few reasons to be grateful and learn some good lessons this week.

The SPX has finally given us a major ride to the downside. Condolences to the many friends who have been predicting it since October last year, but weren’t ready to recognize or profit from it when it came.

Look how it has retraced back up to the 50% FR, before gathering its wits to decide where to go from here. From the chart you will also see that the SPX experienced three white candles, each on lower volume, and each making a smaller new high. Each candle was on lower volume, and the stochastic indicator has just made it into the overbought zone.

I knew that this was a classic swing-traders’ setup … the SPX seemed ready to resume it’s download plunge.

So I started to hunt about for a good stock to play for the downside, in the event that the SPX confirmed my suspicions and began to fall down over the next few days. I ended up choosing CRM.

CRM first came to my notice in October last year … it was fundamentally perfect, with an MSN stock scouter rating of 10, and some very impressive figures as well. Backing up the fundamentals was a lovely strong chart. I had been playing it to the upside and was making quite a bundle. Something happened at the beginning of 2006, (probably some insiders selling stock, or earnings growth slowing down) and I have watched the CRM stock scouter rating slide since then all the way down to 7, its stock price following closely.

But what really grabbed my attention came from CRM’s short term chart. The stock had just reached up to a DOUBLE resistance, the 22dma and a really strong one, the 200dma. The 8,3 stochastic indicator was showing overbought, and the chart really felt like there was some good downward pressure. This was also a good swing trader’s downside entry.

I was also encouraged by the fact that CRM’s downward trend was relatively new, and supported by decreasing stock scouter rating. While the broader market had experienced three large white candles in a row, CRM still had two red candles … so it was showing some downward determination of its own.

Next day by 10:30, both SPX and CRM were tiny little red candles sitting a level just under the previous day’s close. That confirmed my suspicions enough, and I was dead keen to go on in. For some reason I wanted to use CRM August options. Looking back, I don’t really know why. Maybe at that time I was considering a longer-term position. Or maybe I’m just tired of getting unnecessarily hammered with time decay. The August options certainly had better open interest – in fact, I needed the open interest, because I wanted to buy $30,000 worth of them.

My assumptions while entering on 5 June 2006 were the following:

Stop Loss Stock Price: $31.65
Entry Stock Price: $30.19
Target Stock Price: $28.07
Expected change in IV: no change
Expected time to hold position: less than 5 days.

Running through CRM’s August puts, I found that the August 30 Put had the best reward / risk ratio of approximately 2:1, assuming I managed to purchase the option for exactly $2.25

Combined with my ‘conservative’ estimate of 60% probability of success, I found that 60% * 2 / 1 = 1.2, just high enough to justify the trade.

How did the trade go?

By the end of the very next day, the CRM August 30 puts were trading at $3.60. My target price of $3.40 had been triggered, resulting in 51% profit in one day. I wasn’t expecting CRM to drop so far in one day, but it’s great that it did