The "Daily Call" From Option Alpha

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#580 - How Is The VIX Calculated? Apr 25, 2019

Show notes

Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we're going to answer the question – "How is the VIX calculated?" The VIX as you commonly know it as potentially the fear index or the volatility index on the S&P is again, a measurement of the 30-day expected volatility in the S&P 500. How do they judge or how do they measure the expected volatility on the S&P? And it's actually quite simple and it's quite logical if you actually read the white paper that the CBOE puts out. Again, you can look up CBOE white paper on the VIX and you can read all about it and go through the… I think it's like 15 or 20 pages of the actual calculations if you want to. But the end result is that they basically take a weighted average of both near and far term put and call options and they weight the value of those contracts and then derive an implied volatility from those values. It's a little bit of a backwards calculation in the sense that we are solving for implied volatility and trying to figure out – Okay. If people are buying options aggressively or not aggressively at different strike prices and different maturities, how much based on participants buying options are they expecting the S&P to move? Likelihood is that when people are more aggressive at buying options and they price option contracts much higher, they are expecting a much higher move in the S&P because they're moving funds into volatility products or into option contracts that might hedge the potential downside risk of the market.

Now, the components of the VIX, again, are priced in using near and next term put and call options. They specifically say that it's no more than 23 days and no less than 37 days. There's actually a lot of people who would say that they use weekly contracts and although they use weekly expirations, they don't necessarily use weekly contracts in the more traditional sense of option contracts that expire say seven or 14 days. That might be too short of a timeline for how the VIX is calculated. What they're really trying to target is something on average, around 30 days and they use this rolling window between 23 and 37 days to account for different fluctuations in maturities as we go through time. And so, the idea is that they also weight the option contracts that are closer to at the money as having more potential weight because people are buying protection closer to where the stock is trading as opposed to potential stocks or option contracts that are further from the money. We do the same thing when we calculate implied volatility on our end for our IV ranking that we use here at Option Alpha. We use the 30-day weighted average of near and closer near term, next term option contracts and we also weight the different option expirations and the different strike prices to come up with something around 30-ish calendar days. It's a very similar type of methodology that we use to calculate implied volatility. Not all brokers use this type of mentality or this thought process. Many brokers might just take the closest to the monthly contracts or they might have a way to rank one option contract over another, but I think using a combination of different strikes and different maturities ultimately gets us a smoother picture of where things might go.

Again, if you want to look at all the details of exactly what the exact calculations are going into the VIX without this high level that we just went through, again, check out the white paper that the CBOE puts out on the VIX product. Until next time, happy trading.

#579 - What Is An IV Crush? Apr 24, 2019

Show notes

Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we're going to answer the question – "What is an IV crush?" An IV crush or an implied volatility crush happens when the market goes from a period or an event of unknown information to a period or an event of known information. Now, the best example of this is likely an earnings event that a company might go through on the corporate level. Before earnings are announced for a company, the market has a lot of uncertainty. "Where is the company going to announce earnings? Did they make a profit? Are they growing revenues at the appropriate rate? Is there something that they haven't told us that they might tell us during this earnings event?" And so, as a result, we start to see implied volatility or expectation of a big move start to rise heading into that earnings event.

Now, once the company actually announces earnings and all of the information is now known in public, even if the information is bad or even if the information is good, we start to see implied volatility contract or crush and this is again, because we have now crossed between an unknown event and a known event. This is why oftentimes, we start to see stocks have a huge move after earnings, but implied volatility actually go down and it's because even though the stock had a huge move and the company is now re-priced based on earnings, then now, future expectation is a lot more subdued because we now have gone through the earnings event, all the information or worries that we had before are now behind us for the next three months and we can now maybe trade the stock within a tight or a regular range. And so, that's why we see implied volatility go down because market participants now have this known event beyond them. Again, even if the news is really bad, the company missed earnings or had a bad quarter, the fact that the information is now known in public is more important sometimes than what the company actually did during that quarter.

I encourage you to actually look at charts and watch this actually happen. We have videos of this on Option Alpha that you can watch and we have some live videos where you can see the actual implied volatility crush right after the earnings are announced, but I want to encourage you to go back through time and just look at how implied volatility reacts after companies made corporate announcements. And as always, hopefully this helps out. If you guys have any other questions, let me know and until next time, happy trading.

#578 - What Causes Market Volatility? Apr 23, 2019

Show notes

Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we're going to answer the question – "What causes market volatility?" Market volatility is simply caused by unknown factors in the market and that's all there is. I think a lot of people try to overanalyze potentially what volatility means and how it's derived and what causes it, but the simple reality is that when market participants are unsure of a future event, that could be a corporate earnings event, it could be an announcement from a government official, an election, anything that causes uncertainty, we start to see markets behave more volatile.

Now, this doesn't always mean that markets have to crash for volatility to go up. In fact, we've seen time and time again that markets can actually go up and implied volatility or market volatility can also increase as markets are rising. We've seen this not only in the commodity markets, but also in markets like emerging markets after elections or after big announcements from FED officials and bond markets. We see this all the time, again, as it relates to uncertainty. Whenever the markets are certain, even if the news is bad or if the news is good, we'll generally see lower volatility, but when the markets are uncertain of a future outcome or expectation, that's where we start to see volatility and a lot more trading ranges start to appear on the charts. Hopefully this helps out. As always, if you have any questions, let me know and until next time, happy trading.

#577 - What Is A Long Strangle? Apr 22, 2019

Show notes

Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we're going to answer the question – "What is a long strangle?" A long strangle option strategy is again, an aggressive option buying strategy whereby you are purchasing option contracts on either end of where the stock is trading currently. For example, if a stock is trading at say $100, you might purchase the 105 call option and the 95 strike put option. Now, this creates that straddle payoff diagram which is basically a very aggressive option buying strategy in which you are looking for the stock to make a large move in either direction. Now, because you're not buying options at the exact same strike price, you do have the ability with a long strangle to be fluid with your option strikes and purchase option contracts either far out of the money or close to at the money, depending on how aggressive you want to be with your strategy and how far you think the underlying stock is going to move.

Now, all this being said, a long strangle strategy is by far, one of the worst strategies you can consistently deploy in an options trading system and it's because of implied volatility's premium that we recognize in the difference between implied volatility and historical volatility and also the time decay that is present in option contracts. Now, we actually know from back-testing and lots of research not only here at Option Alpha, but other places as well online (you can research and find this out as well) that long strangles are actually one of the worst-performing strategies and therefore, short strangles, selling options that people look to purchase out of the money ends up being one of the more profitable strategies you can use. As always, if you have any questions, let me know and until next time, happy trading.

#576 - What Is A Long Straddle? Apr 21, 2019

Show notes

Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we're going to answer the question – "What is a long straddle?" A long straddle is an aggressive option buying strategy whereby you are purchasing the exact same strike call option and put option. For example, if a stock is trading at say $80, you would buy the 80 strike put option and purchase the 80 strike call option and that's what creates the straddle payoff diagram. Now, this option strategy like I mentioned, is an aggressive option buying strategy because you are looking for a large move in the underlying stock in either direction. It is a neutral strategy, but you have to get a move in the underlying stock that is more than the combined premium you purchased the option contracts for.

For example, if the stock is trading at say $80 and you purchase the 80 strike call and the 80 strike put and the combined purchase of those call options cost you $5, your breakeven points are now $75 and $85. And so, therefore, you need the stock to make a larger than $5 move in either direction before expiration to have an opportunity to start generating some money. Now, intuitively, we know from back-testing and research that long straddles are quite possibly one of the worst trading strategies you can use on a consistent basis. Now, this doesn't mean that it won't profit in some certain environments or if you get lucky and pick some directional plays before a big move, but long-term, long straddles are a losing strategy because of time decay and because of implied volatility in the option contracts. Hopefully this helps out. As always, if you have any questions, let me know and until next time, happy trading.

#575 - How Soon Can You Sell Stock After Exercising A Call Option? Apr 20, 2019

Show notes

Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we're going to answer the question – "How soon can you sell a stock after exercising a call option?" We're going to go off the assumption that you had a long call option which again, gives you the right, but not the obligation to purchase stock at the strike price in the future. And let's say that you acted on that right and you purchased or exercised your call option which therefore, allowed you to purchase stock at your strike price. Assuming your strike price is $100 a share, you would exercise your 100 strike call option and you would purchase stock at $100 a share. Now, the question is – "How soon after exercising this call option can you sell the stock back?" And the answer is as soon as the stock hits your account, you have the ability to sell it right back. If you exercise that option contract and it takes half a day for the brokers to actually deliver the shares to your account or if it takes 15 minutes for the brokerage to deliver the shares to your account, whenever the shares actually hit your account and you're now long stock, you can immediately resell that stock in the future right back into the open market.

Now, even though that's logistically how it goes, the other side of this is I don't know why you would want to do this immediately. If you are in the position where you're thinking about exercising a call option and then selling the stock, that would be the equivalent of just closing out the call option and selling it back in the open market. In fact, you'd probably save a lot of money and you wouldn't give up any time decay or volatility premium that's left in the option position. My feeling is that anybody who's going to exercise a call option and hold stock has hopefully a longer-term outlook or at least a medium-term outlook that the stock is going to continue to move higher, in which case, they want to own shares and want to hold shares. It's probably not the best way to go to exercise a call option and then immediately sell stock. It's a more inefficient way to get rid of the position and ultimately will cost more in commissions. Hopefully this helps out. As always, if you guys have any questions at all, please let me know. Shoot them over to us at optionalpha.com/ask and until next time, happy trading.

#574 - Adjust Your Option Orders In Penny Increments Apr 19, 2019

Show notes

Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we're going to be talking about why you should adjust your option orders in penny increments. I'm a big fan of getting into option positions at a known price and taking your time with order entry. I think a lot of people for some reason (and I have no idea why this is) feel like they should rush order entry. When you get into a position, there's this overwhelming sense of urgency that most people have to force the position into the market. Like magically, if I don't get into this position and this opportunity, I'm never going to have another trading opportunity come by my screen. But it's just not the case. After trading for over 10 years now, I know that there's always another trade to be had later on. If this trade doesn't work out or if the pricing doesn't work or if I can't get a fill on the position, I know for sure that tomorrow, there will be another opportunity.

For some reason, I don't think people think like this and so, for that reason, many people use market orders. They adjust pricing way too quickly and are impatient with how they adjust their orders or they make too big of adjustments to positions as they try to enter orders. My thought process on this is first, obviously to be patient. Let orders work. I mean, orders are meant to be working in the market because they're trying to match up parties and just because you clicked the mouse right now does not mean that someone else is exactly ready at that same time and point to make another opposing trade to yours. It doesn't work like that. In markets, we have to find buyers and sellers for each side of the position and that takes time. Moreover, I think you should adjust your pricing by penny increments and I'm really, really big on this because I don't think you should rush pricing and order entry.

My philosophy on order entry is if you are placing an order to sell a spread say for $150, so 1.50, then you let that order work in the market for 15, 20, 30 minutes, depending on how liquid the underlying is and how much it's moving. You just let that order work for a good amount of time, see if you can actually get filled. If you feel like you want to get filled on that and you are comfortable, then you adjust it down by just a penny and then again, repeat the process, let it work in the market for another 15, 20, 30 minutes, but you adjust it down to say 1.49 and then after time, you adjust it down to 1.48 and 1.47 if you want to keep going that route. But at some point, you're just going to have to realize that after the end of the day, making two or three adjustments to pricing and you're still not getting a fill, it might just be better to cancel it and move on and wait the next day and try to enter it again later on.

Again, I'm a big fan of just adjusting down in penny increments and then waiting for an order entry and again, if it doesn't come, there's always another trade to be had the next day. Hopefully this helps out. As always, if you have any questions, let me know and until next time, happy trading.

#573 - What Is Bottom Fishing As It Relates To The Stock Market? Apr 18, 2019

Show notes

Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we're going to answer the question – "What is bottom-fishing as it relates to the stock market?" You might often hear people say there's some bottom-fishing going on or we could see some bottom-fishing when it comes to stocks and basically, it's this concept that at some point, either the regular market or any particular stock or ETF that you're trading gets sold off enough that we find people coming back in and fishing for good opportunities. And so, I don't know why they call it bottom-fishing. Maybe because it creates the bottom in the market. But inevitably, when we see something sell off, it now becomes a better opportunity. You take one company that has the same stream of cash flow and it's trading at $100. Well, now, if it sells off to $80, that same stream of cash flow hasn't changed, but now, the price of the equity has changed from $100 to $80 and now, it becomes a more attractive investment and that's as simple as it is.

When you see the market go down or you see stock start to go parabolically lower, at some point, there's going to be somebody who's going to come in and start fishing for opportunities. They're going to start placing bets. They're going to start entering the position, going long the market, buying up equity because they feel like now, the price has gone low enough that it creates an opportunity. This happens in all markets and all cycles. It's not just the stock market. It happens in real estate, in business and in investing and it happens everywhere. When the price of an underlying asset gets low enough to make it attractive, somebody's going to come in and start purchasing it and that's what helps slow the decay or the decline of the asset and create that bottoming effect. Hopefully this helps out. As always, if you have any questions, let us know and until next time, happy trading.

#572 - Short-Term Memory Loss Is Critical For Options Traders Apr 17, 2019

Show notes

Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we're going to be talking about why short-term memory loss is critical for options traders. This concept of short-term memory loss for me actually goes back to high school. I've talked about it often on the podcast, but I had a coach in high school which was very influential on me, happen to coach me not only in baseball, but also in football and coach Anderson used to always say to me, "Look. You got to have short-term memory loss." If you throw a pick or if you make a bad read or you overthrow a receiver that's wide open in the end zone, you ultimately have to forget it and move onto the next play. And this was really important to me because over time, what I realized is that if I had a bad play or if I did something wrong or I just had a bad read that it wasn't going to affect the outcome of the rest of the game, that I could quickly forget it because I needed to have short-term memory loss and I needed to move onto the next position.

Now, it doesn't mean that we would not learn from those experiences. We'd go back and we watch the film and we'd reflect on it and we'd see where we could improve obviously and make adjustments along the way. But when you're in the middle of the game, when you're actually doing play after play after play, you got to forget some of the time that you have a bad read or you have a bad play because ultimately, if you let it basically linger and you let it erode your confidence, you're not going to be a good player. I think that when it comes to trading, the same can be true when it comes to positions that are not great entries or go sideways or if you have a fat finger trade, sometimes people just hang onto these positions and let them erode and act like cancer internally for your confidence and you can't do that. You have to move on from those positions and from those trades and look at the next opportunity because there's always an opportunity to make an improvement in the future, so long as you can learn from the past and then forget those things and don't let them harbor your ability to make better positions.

I think today's key lesson here is we want to learn from the things that we do, but when we're in the moment of making trades, we can't let a losing trade just really drag our confidence lower and become this huge weight or anchor that drags us down. We have to forget some of these trades sometimes and move onto the next ones, so that we can keep up with our trading activity and high-frequency which we know is important for long-term success. Hopefully this helps out. As always, if you have any questions, let me know and until next time, happy trading.

#571 - Pros & Cons of Placing A Limit Order Apr 16, 2019

Show notes

Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we're going to talk about the pros and cons of placing a limit order. A limit order when trading options is simply an order that specifies exactly what your maximum price is that you are willing to pay or your minimum credit in which you're willing to accept if you are selling options. I prefer to do all my orders using limit orders and the reason I like them is because I know exactly where I'll get in and where I'll get out whenever the order gets filled. Now, that obviously to me is the biggest pro of using limit orders. You can naturally adjust limit orders multiple times and you can do this actually very quickly. You can place an order for $150 and if that order doesn't get filled, you can quickly readjust the order and place it for $151 effectively creating your own little market order, but you are in control of the prices that you're posting and the prices that you're using.

Now, if we take the flipside of this and look at the cons of using a limit order, is that naturally, most of the time, you're going to have a little bit longer waiting period to get filled. If you are specifying an exact price and you're trading a product that may or may not have a lot of liquidity, then it may take longer for you to fill that position. In fact, many times, the market may trade around your limit order and you still might not even fill because it's got to find and pair you up with somebody else at that exact same price. The con of using a limit order is the latency that's required to get the position filled. And so, for the most part, many people would default to using a market order, but I would highly suggest you shy away from using market orders because they really could fill at any next available price. And so, I am of the opinion that most of the trading that we do is not so heavily reliant on getting filled at the exact perfect price of a penny versus two pennies off that I would rather just wait and make sure I get filled at a price I'm comfortable with. Many people like to use market orders because they force trades in, but sometimes when you're doing that and the market bid ask spread is wide, you could get insanely different pricing than what you might expect. Hopefully this helps out. As always, if you have any questions, let me know and until next time, happy trading.

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