Trading Options in Turbulent Markets

The United States used to be a good place to make assumptions.Young men and women were admitted to college without creating marketing videos of themselves and without pledging their teenaged years to an extracurricular cloister. College arrived, and college led to graduation (four years), a cubicle, modest debt, spouse, offspring, real estate, health insurance, trips to Disneyland.

Nurses and math teachers did not need resumes. Single family homes increased in value every year. That’s written in the Bible somewhere. People in their 50s and 60s owned homes that were paid off. If you had been working somewhere for 20 years or more you could safely hide in your office until you turned 65, and at that point, with your golden years ahead, Social Security would be waiting patiently. Forever would Americans buy Kodak film, books at Borders, tools and trousers at Sears.

When recession did arrive (the non-Great kind) a company like Circuit City might dally with Chapter 11, but only long enough to get reorganized and draw enough investment capital to return to health. If a developer was stuck with an office tower or apartment project that was still unfinished when economists announced that the downturn had started, the investors pushed to finish the property anyway, and then made an effort to find tenants. Walking away from a property with rebar sticking out of the top was unthinkable. And regardless of the economy, talk of Chapter 11 for icons like General Motors or Bank of America was the province of conspiracy theorists with greasy hair and smudged glasses.

Option Trading

The end of the last century offered engineers writing software in Mumbai and Moscow and Chinese factories that assembled, well, everything. The Internet shook the planet even more than Gutenberg’s invention did more than five centuries earlier. And then the strangely old-fashioned financial panic of 2008 arrived.

The panic has subsided, but the rubble remains:

The venerable United States Postal Service lost a third of its first-class mail volume and started talking of eliminating Saturday delivery for the first time ever as one of the possible cutbacks needed to remain solvent. Public libraries across the country closed their doors. Firefighters and police officers were laid off. The town of Vallejo, California, filed for bankruptcy. For 15 years, from 1991 through 2005, Bill Miller, the chairman and chief investment officer of Legg Mason Capital Development, was a superhero for investors. Every year he outperformed the Standard & Poor’s 500, a record unmatched by any competitor, and his fund assets peaked in 2006 at $20 billion. But after the financial crisis started, the old wisdom of the markets no longer worked for him. Miller snapped up bank stocks in the midst of the crisis, expecting them to recover. They didn’t.

In 2008, his fund lost more than half of its value, investors headed for the exit, and by the time Miller retired at the end of 2011, his fund’s balance had slid to less than $3 billion. Greeks responded to talk of austerity with riots, and Italy (a G6 member) trembled close to defaulting on its bonds, as its debt to GDP ratios reached levels not seen since the end of World War II. Europeans talked of abandoning the euro—and their southern neighbors to their fates. By the end of 2011, the U.S. middle class had watched $8 trillion in home equity vanish. Some 11 million families lost their homes to foreclosure, and throughout 2011 as many as one out of every three homeowners found that their properties were worth as much as 25 percent less than the amount remaining on the mortgage.

Trading Options in Turbulent Markets In this book, options expert Larry Shover skillfully addresses how to use historical volatility to predict future volatility for a security, or the implied volatility, and offers suggestions for dealing with that odd feature of options trading known as skew. Type: eBook (PDF) Price: $ 11 USD

The term “underwater” had to be invented in 2008 to describe homes that were impossible to refinance and hopeless to sell. By January 2012, U.S. homes had lost, on average, a staggering 40 percent of their value. The total amount of student loan debt passed the total amount of credit card debt for the first time ever. New graduates struggled with crushing debt burdens even as they faced crippling levels of unemployment. Books and articles for the first time repeatedly questioned whether a college degree was really worth the money. The Federal Reserve and European Central Bank offered stimulus.

Again. Did anyone notice? U.S. Treasury bills remained at least a safe investment, but yields on these bonds fell below 2 percent, and on 30-year bonds, below 4 percent, their lowest rates ever.

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Egypt, the largest country in the Middle East, saw mass demonstrations that overturned a dictator. Nothing like that had happened in the nation’s 5,000-year history. Civil war toppled a dictator in Libya and threatened Syria to the north.

Mass protests swept the United States, too. The longest war in U.S. history stumbled on in Afghanistan, though still without clear goals. Relations soured further with a critical ally, Pakistan. Troops were at last withdrawn from Iraq. The U.S. government could not convince the Iraqis to allow it to maintain a military presence, leaving the country—and its oil reserves—to a very uncertain future.

Meanwhile, talk of an attack on Iran persisted, prompting the Iranian government to threaten to close the Strait of Hormuz to shipping. This act, easily within the reach of the Iranian military, would lead inevitably to a disastrous spike in oil prices.

The U.S. House of Representatives pushed the U.S. Federal government to within a few weeks of defaulting on its loans and a new global depression in a debate over raising the debt ceiling.

For the first time in U.S. history there was discussion of invoking the Fourteenth Amendment to guarantee the government’s solvency; for the first time ever, the government’s credit rating was lowered.

Who wins the Oval Office in 2012? What will Congress—facing approval levels in the single digits—look like? Will the government start to actually work again? And what vision would guide the government if, in fact, it does manage to start producing something in 2013 other than parliamentary maneuvers, stalled appointments, and filibusters?

Welcome to 2012, the Age of Uncertainty. Nobody knows. The same amount of uncertainty applies to the modern investment community. Computer models still press on, but traders no longer dare to make predictions, because they frequently no longer have any idea what to expect. A trader’s judgment can be reduced to coincidence, or a gamble. Maybe a market swings simply because a single hedge fund completes a large off-floor trade or a major bank starts buying up puts to cover its exposure after issuing warrants. Or one might decide to make a trading decision only when the moon is full, or find that based on past experience, on the third Friday of March or December, if the S&P 500 index has dropped three days in a row, it’s a good time to start buying Swedish municipal bonds. A careful review of these trends six months later might show that they were in fact accurate. But that doesn’t make them any less silly. You can find a lot of truth in using hindsight to explain past performance but still find that hindsight useless in predicting what happens next, especially now.

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Trading is all about human frailty. We live in a world with people who become greedy and shortsighted, who panic, who make blunders and then try to hide them, who try to protect their jobs, who lack experience, or who grow complacent. And all of this frailty and folly is in high relief in a modern world where nothing makes sense any longer. Seasoned traders talk of a time when they could sense where the market was going, when they could manage positions without desperation, when certain rules applied to how the markets would behave next month or next year.

For many years, people with PhDs working at trading firms on Wall Street produced models that efficiently predicted market value for securities. However, these scholars failed to plan—or were unable to plan—for rare events, much less the current era of violent volatility and fiscal and social chaos. Further, the very value of experience itself has been called into question of late. A trader with 25 years of experience and a career noted for its rigorous success can now be found to be losing money six months in a row, while a new graduate—with a freshly minted MBA—can have a run on the market that can make him the toast, and the envy, of his older peers. Why? Skill or luck? Something else? We can no longer estimate how well a given trader will do based on that trader’s background.

As of this writing, it appears that the 25-year period of the “great moderation” is over, and, in fact, may have been somewhat of an historical anomaly. Since 2008, we’ve found ourselves struggling to deal with markets and an economy besieged by uncertainty.

Trading Options in Turbulent Markets is a book about how to think about options trading in terms of our modern world of randomness and volatility. This book was written with the hope of filling the void in tradi- tional financial literature by combining theory and real-world practice with the awareness that the world we live in is completely random and that vol- atility is nothing but an expression of that randomness. The book draws from the premise that volatility isn’t just standard deviation or a number generated from the Black-Scholes calculator. It is the sum of all the information we simply don’t possess.

In an era full of so much uncertainty in all of the financial markets, and with the global investment community arguing about how well super- computers can predict rare events—predict the unpredictable—I decided to write an expanded second edition about options trading. One can find an abundance of high-quality books about options trading, and plenty that address volatility analysis. I sought to write this second edition uniquely combining options trading and volatility in a universe that is beyond control and sometimes terrifying.

Face it; the past three decades have been the exception, not the norm, for investors in equity markets. To this day, Wall Street seems to be dedicated to the principle that when it comes to trading the markets, there is such a thing as expertise; that skill and insight count in trading, just as skill and insight count in surgery or baseball. But the common thread of this book is to show that options do not behave in the way that physical phenomena such as mortality statistics do.

Physical events, whether death rates or card games, are the predictable function of a limited and stable set of factors and tend to follow what statisticians call a “normal distribution,” or a bell curve. Markets do not follow any normal distribution. Markets are not normal. This book is intended to help you understand that even though you may hear that 90 percent of all options expire as worthless, the 10 percent that don’t can create devastating results. The best computer modeling tools often fail to predict option contract prices and which options contracts are likely to be exercised. This uncertainty is largely caused by investors and traders who don’t act with any statistical orderliness. We change our minds on a whim. We do stupid things. We copy each other. We panic.

The options market has grown at a record pace over the past 25 years. Today, you can bet on whether a stock goes up or down. You can buy or sell options on bonds, on foreign currency, on mortgages, or on the relationship among any number of financial instruments of your choice; you can bet on whether the market booms or crashes or stays the same. Options allow investors to gamble heavily and turn 1 dollar into 50. They also allow investors to manage their risk. What drives the options market is the notion that the risks represented by all of these bets can be quantified, that by looking at the past behavior of a stock, you can calculate out the precise likelihood that the stock will reach a share price of $25.45 by next November 30, and whether the option is a good or bad investment at that price. Actually, the process is a lot like the way insurance companies analyze actuarial statistics in order to determine how much to charge for life insurance premiums.

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But despite all the growth and the vast sums invested in derivatives trading today, we still face a stunning amount of uncertainty in the markets as in life. Addressing this uncertainty as options traders is what this book is about.

Option Trading in Turbulen Markets

Part One focuses on how volatility in options trading relates to today’s stormy marketplace. The book reflects on the 2008–2012 era—a period full of randomness, uncertainty, and risk—and how this uncertainty leads to volatility in the financial markets. Of course the world has always been random, uncertain, and risky. But the financial markets were not so com- plicated even 25 years ago, the trade volumes and dollars invested were not nearly so vast, the markets were not dependent on enormously complex computer modeling tools, and the financial marketplace did not experience unprecedented volatility as it has over the last few years.

Part One also addresses how to manage risk and how to take advantage of market volatility when investing in derivatives. The book demonstrates how to take advantage of market volatility when investing in derivatives. It shows how to use historical volatility to predict the future volatility for a security, or the implied volatility.

Part One deals with that odd feature of options trading known as skew, in which the options market has, in recent decades, essen- tially developed its own consciousness and can respond to market conditions that defy all logic. Skew is uncertainty squared. I describe how to work with skew or work around it.

Lastly, Part One confronts the overwhelming fixation with VIX, the selfproclaimed fear gauge of the market! This section helps to unpack VIX, pro- viding the investor with practical application on what VIX is what it isn’t and how it can lead or even mislead in making options trading decisions.

Part Two digs into the tools for evaluating options trading decisions, the Greeks: delta, vega, theta, and gamma. It defines the values carefully and describes how each relates to volatility. Part Two takes this discussion one step further with an in-depth look into some of the more intricate details of volatility in an informative, easy-to-understand format. Institutional terms such as “realized volatility,” “term-structure,” “vol of vol,” and “correlations” are dissected with the investor in mind—boiling them down to where they can be both helpful and relevant to readers of all stripes.

Part Three provides strategies for trading options contracts in uncertain times. First, we address the decision-making process in broad terms and discuss how to become a steel-nerved trader. When does a trader know how to tolerate risk? How does a successful trader think or respond to adversity? How does a trader lose well?

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Moving on, the book looks at specific options trading strategies to offset risk and reach for profit. These include the covered call, the naked and married puts, collars, straddles, vertical spreads, calendar spreads, butterflies, and condors, along with other various and sundry wingspreads. Part Three focuses on ways to use these strategies in a volatile market, how volatility affects each method of investing, and how to blend these strategies to control for risk. It explores how to open doors to making a profit even when nobody has any idea what is likely to happen next, when it seems there are long odds on any event other than the sun perhaps rising the next morning.

You can prosper in options trading, even in the midst of chaos. And despite the risks, options trading can be fun, invigorating, and, for a wise trader, an excellent means to profit, even in uncertain times.

Trading Options in Turbulent Markets In this book, options expert Larry Shover skillfully addresses how to use historical volatility to predict future volatility for a security, or the implied volatility, and offers suggestions for dealing with that odd feature of options trading known as skew. Type: eBook (PDF) Price: $ 11 USD