Just as an example, when the last bear market began in March2000, VIX was near 20. By the time that bear market bottomed, inJuly or October 2002, VIX had risen above 40. Hence, one VXfutures contract (had they existed at the time) would have appreciatedby $20,000.Such random or selective data points don’t make for a long-termstudy, though. So let’s construct a more rigorous study. Table 3.6compares the semiannual changes in VIX and SPX in percentageterms. The final column shows how a trader’s portfolio would havedone had he invested 90 percent of its assets in the SPX and hedgedthat by taking a 0.1 position in VX futures—in other words, the righthand column is 90 percent (0.9) of the percentage change in SPXplus 0.1 the change in VIX.With just this simplistic model—long 90 percent SPX and long10 percent VX futures—one can see the benefits of the hedge. Thetotal profit is nearly the same, where the total of the “SPX %” column is 108.6, and the same total for the hedged position (the righthand column) is 105.6. However, the volatility of the portfolio wasgreatly reduced. Notice that during the bear market, the SPX wasdown five periods in a row; but in four of the five, the hedged portfolio lost less (since VIX rose during those quarters). To put it in statistical terms, the standard deviation of the semiannual returns wasnear 11 percent for the SPX, while it was just above 9 percent forthe hedged portfolio. Hence, the hedge not only reduces losses in a
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THE VERSATILE OPTIONTable 3.6A SEMIANNUAL HEDGE WITH VIX FUTURES
VIX
SPX
VIX%
SPX%
0.9*SPX%+0.1*VIX
199302012.33199308011.47199402010.64199408011.16199502011.72199508013.55199602012.64199608018.76199702019.57199708022.29199802021.35199808025.98199902027.67199908025.58200002023.45200008020.54200102021.66200108020.55200202021.11200208036.95200302031.01200308020.75200402017.11TotalsStandard Deviation
442.5450.2479.6461.0470.4559.6638.5650.0786.7947.11001.21112.41273.01328.01409.21438.11373.41215.91122.2884.6860.3980.51135.2
–7.0–7.24.95.015.6– 6.748.44.313.9–4.221.76.5–7.6– 8.3–12.45.5–5.12.775.0–16.1–33.1–17.5
1.76.5–3.92.019.014.11.821.020.45.711.114.44.36.12.1–4.5–11.5–7.7–21.2–2.714.015.8108.610.9%
0.95.2–3.02.318.612.06.519.419.74.712.213.63.14.70.6–3.5–10.8–6.7–11.6–4.19.312.4105.69.2%
Date
bear market, but it also reduces the volatility of the portfolio’s returnswhile not harming the overall return significantly.The forgoing study is really quite simple. A more complicatedstudy was performed by Merrill Lynch published under the title,“Volatility—The Perfect Asset?” While it is quite mathematical innature, several conclusions are drawn from the paper: a portfolio oflong 10 percent VIX and long 90 percent SPX, rebalanced weekly,
USING VOLATILITY FUTURES AS PORTFOLIO INSURANCE
183
has outperformed the S&P 500 Index by about 5 percent per yearwith 25 percent lower risk since 1986. (Note: the strategy made alarge amount of money, theoretically, in the crash of 1987 since VIXrose nearly sevenfold on the day of the crash; this fact helps the overall returns since 1986. Without including 1987, the yearly outperformance was about 2 percent—still very respectable, considering thelowered volatility of the combined portfolio.)
What Can Go Wrong?The theoretical studies just mentioned did not encompass one thingthat we had shown in our original examples—there may be a premium in the futures contract. If one had to pay a premium consistently, that would reduce returns for the hedging strategy.When can we expect the futures to have a premium? When theyare low-priced. The reason I can state that with some assurance isthis: VIX trades in a range. Its lifetime low is about 10, and its lifetimehigh (excluding the crash of 1987) is about 60. So when VIX is near10, speculators will be buyers along with hedgers; and VIX will probably trade at a premium as a result. When VIX gets expensive—say,at or above 40—then VIX will probably trade with a discount, sincesellers figure it will decline from there. The latter (discount) is less certain than the former (premium) because VIX could temporarily spikequite high, as it did in the 1987 crash.However, it is a certainty that VIX cannot go below zero and cannot go up forever. So the lower it goes towards zero, the more buyers there will be among speculators; and the higher it goes, the moresellers there will be. The speculative activity is likely to put a premiumon the futures when they are low and perhaps produce a discountwhen they are high.So, suppose that we as hedgers pay 160 for the futures whenVIX is 15.0. Yet, nothing transpires that quarter, and VIX is literallyunchanged at quarter’s end. So the futures expire at 150—a loss of$1,000 per contract. Now, the hedger must buy the next futurescontract, which is likely to have a premium; and the whole procedurecould repeat itself. As long as VIX remains low-priced, the premiumon the futures will likely persist, and the cost of the hedge will beincreased by the amount of the premium.
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THE VERSATILE OPTION
I view this as the biggest problem with the hedging strategy. Howexpensive will the premium be? It’s hard to say at the current time;but since VIX can’t be arbitraged* (there is no underlying or equivalent), it won’t necessarily remain at “fair value” and, therefore, thepremium may be larger than expected. Even so, the strategy is worthconsideration by any holder of stocks.
Options on VX FuturesEventually, the CBOE intends to list options on VX futures. Maybesomeday there will even be options on the volatility of individualstocks, like IBM. But even with options on VX futures, the hedgingpossibilities expand for the stock investor. Rather than buying VXfutures to go along with a portfolio of long stocks, the investor couldjust buy out-of-the-money VX calls instead. Then if VX spikes, thecalls would profit. However, if VX stays in a trading range, the callshave much less risk than the futures would. Therefore, they wouldpresumably be less of a drag on performance in rising and flatmarkets.For example, if VIX were trading near 15, rather than buy theVX futures, an investor might buy VX futures calls with a strikingprice of 30. The calls would profit if VIX moved above 30 before thecalls expired, which presumably would happen in a sharp marketdecline. This is much better than buying SPX puts, say, because theprotection is still dynamic. No matter where the SPX is trading, whenit begins to fall sharply, VIX will rise, and the calls will be providingportfolio protection. Since VIX moves in a more or less constant*In order to be able to arbitrage the VX futures, one would have to be able to tradethe VIX itself as a cash index or trade an equivalent. You might think that you could,for example, sell a representative portfolio of SPX options on the CBOE and buyVIX futures as a hedge. That is not arbitrage. One big problem is that the volatility ofthe SPX options eventually converges on the actual volatility of VIX at expiration,but VIX does not ever have to trade at a level equal to actual SPX volatility. Also, thesale of SPX options introduces other risks—price, time, delta, and gamma—not justvolatility. Hence, there is no arbitrage. But if the premium on VX futures were to getextremely far out of line, the arbs and market makers would execute the SPXoptions versus VX futures trade as a hedge, trying to capture some of the differentialfrom fair value at which the futures are presumably trading. This risk hedging actionwill help to keep VX futures “in line,” but it won’t guarantee by any means that theywill trade at “fair value.”
USING VOLATILITY FUTURES AS PORTFOLIO INSURANCE
185
range, owning VIX calls at 40 would always be an effective hedge ina severe market drop. But that’s not the case with SPX puts. If themarket rallies strongly after you buy SPX puts and then later collapses, the puts’ strike may not be close enough to the SPX price toprovide any protection to the stock portfolio.When and if the VX options begin trading, an investor will needto use the “volatility of volatility” to price them. In others words, theactual (historic) volatility of the VIX will be used as one of the inputsinto the Black-Scholes option pricing model in order to price suchoptions. The volatility of VIX is surprisingly large. You might think itwould be small since VIX constantly trades in a range betweenroughly 15 and 35, but it does so in a phrenetic manner. So thevolatility of volatility (VIX) is higher than you might expect—generallyranging between 50 percent and 120 percent. Figure 3.2 features a
Figure 3.2VIX VOLATILITIES20.020 19.200
19.680
20030909
50-day HV100-day HV
20-day HV
$VIX price
67.00059.00051.00043.00035.00027.00019.00011.0003.000
J A SO N D J F M A M J J A SO N D J FM A M J J A S20012003
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THE VERSATILE OPTION
chart of VIX with the 20-, 50-, and 100-day historical volatilitiesgraphed above it. Just during the two-year period 2001–2003, the20-day volatility ranged from 42 percent to 140 percent.
SUMMARYIn this chapter, we presented some basic option methodology thatcan be very profitable in a number of situations. An understanding ofthe option positions that are equivalent to being long or short theunderlying is a useful tool, and a mandatory one for futures traders.Considerable time was spent explaining how great an effect S&Pfutures have on the stock market, and then strategies were laid outfor profiting from that knowledge, especially at expiration of optionsand futures. Finally, techniques for protecting a portfolio of stockswith options were demonstrated.
4
The PredictivePower of Options
Options can sometimes be a very useful tool for predicting the movement of the underlying instrument. In certain cases, option statisticsare sentiment indicators, indicating what the “public” is doing. Inother cases, it pays to watch option volume and pricing levels because“smart money” might be buying options in preparation for a move byan underlying stock. In this chapter, we explore how to use and interpret option statistics for the purposes of trading the underlying.
USING STOCK OPTION VOLUMEAS AN INDICATORMost traders have noticed, or at least have heard financial commentators mention, the fact that a takeover offer or other surprise corporate announcement was “tipped” off by heavy option trading on theday(s) preceding the actual announcement. Obviously, someone hadadvance knowledge of the corporate event, or at least rumors werestrongly circulating among the “in crowd.” Of course, most peopleonly find out about this heavy volume after the fact.A significant increase in the trading volume of a stock’soptions often is a precursor of movement by the underlyingstock. This statement is only true if the volume is speculative innature. If the increased volume is due to irrelevant factors, such asarbitrage or spread trading, then it is meaningless as far as predicting stock movement. Later, we discuss methods for screening outsuch irrelevant data.
187
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THE PREDICTIVE POWER OF OPTIONS
The reason that the preceding statement is true is leverage.Those with inside knowledge will buy options because they can scorehighly leveraged gains when that knowledge becomes fact. For thesame reason—leverage—they prefer to buy options rather thanstock. Their “tracks” are visible to the entire investment community,in terms of increased option trading volume. Whether those insidersare acting legally is unimportant, for it is perfectly legal to monitoroption volume and trade accordingly.I’ve had some traders argue with the premise that those withinside information buy options rather than stock, and I usually askthem this question: if you had tomorrow’s newspaper, what wouldyou do, buy stock or options? Actually, the correct answer to thatquestion is “play the lottery,” but you get the point. If you know youhave an almost sure thing, you would look to maximize your percentage returns as much as possible. By the way, if you ever do get acopy of tomorrow’s paper and there isn’t any lottery tomorrow, thenhead out to the race track.It should be pointed out that stock volume also often increasesprior to major corporate announcements. Some of the stock volumeis spillover from the option pits as market makers rush to buy stockto cover some of the options they have been selling in the course ofmaking markets. Also, the stock market is generally more liquid thanthe option market, so the insiders may be forced to buy stock inorder to amass a large position. However, it is the option volumethat provides the most reliable clues to the major corporate announcements that make stocks move: earnings reports, takeoversor mergers, and filings or settlements of major lawsuits.
How Much Is Too Much?When looking for “increased option volume,” don’t be concernedwith the most active options. These are two distinctly different things:increased option volume refers to the amount of trading in a stock’soptions compared to the average number of options traded on thatstock. The stocks with the heaviest option volume are likely to beIBM or Philip Morris, for example, but any stock can see its optionvolume shoot up to high levels when compared to its normal volume.
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189
On a typical day in the summer of 1995, the most active optionable stocksand their average option volume were:
Stock
Total OptionVolume
Average OptionVolume
IBMIntelMicron TechMicrosoftCompaq
37,70536,98425,53922,45518,409
33,74330,68821,56921,37111,973
As you can see, the high-tech stocks dominated the trading volume.There is very little that is unusual in these figures when you compare thetotal volume for that particular day with the average volume. However,these volume figures were also traded on that same day:
Stock
Total OptionVolume
Average OptionVolume
NovellHome ShoppingIntegrated SiliconMaxtor
24,4101,4301,1581,670
8,489148368557
You can see that the ratio of total option volume to average volume oneach of these four stocks was at least three-to-one and was quite a bit largerfor Home Shopping Network. On that particular day, Novell’s option volume was due to news that was already out (bad earnings), but the otherthree were definitely ones to watch, as their option volume might be foretelling some significant corporate news. As it eventually turned out, notmuch happened in Home Shopping or Maxtor, but the Integrated Siliconvolume was another story. The option volume shown here mostly consistedof puts, which was a bearish indication by the options. The stock fell 14points within a week, an excellent trade produced by option volume.
It is situations of this latter variety that can alert you to stocks thatare about to make significant moves. If there is excessive call optionvolume, then you would expect to see positive news announced soon
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THE PREDICTIVE POWER OF OPTIONS
and would look to buy the underlying stock. If there is excessive putoption volume, then a short sale is possible because bad news maybe just around the corner. If there is excessive volume in both theputs and the calls, it is my experience that the stock is generally leaning to the positive side, but not always; so you should be ready for abreakout in either direction and follow it in that case.
The AnalysisNow let’s discuss, theoretically, the steps to follow after first spottinga potentially true high-volume situation. After that, we discuss someof the specifics (and problems) involved with applying this theory.Experience has taught us that only situations in which today’s totaloption volume is greater than double the “average” option volumeare worth exploring; and where the options are normally very active,an even greater ratio is desirable. Once one of these high-volume situations has been identified, some additional work must be done.First, you must screen out situations where the option volume isrelated to nonspeculative things, such as arbitrage. On a given day,you may find between 40 and 60 different stocks that have tradeddouble their average option volume. As expiration approaches eachmonth, that number can swell to well over 100 underlying issues. Inreality, only a handful of these have true speculative volume; the others can be disregarded after careful analysis. This analysis can betime-consuming, but computers can help to a certain extent. Overthe years, though, we have found that it can be a mistake to let thecomputers screen out too many situations. If you miss just one 20point takeover because you were trying to save yourself a couple ofminutes of analysis each day, you will rue your decision.One screen is to see if too much of the total volume is concentrated in too few options. If almost all of the option volume is concentrated in one series (that is, just one call or just one put), thenit is unlikely that anything special is going on with that stock. Forexample, if most of the total volume is in one call series, then it isquite likely that an institution executed a sale of calls against stockthat they own. This sale of options would most likely be executed atone time and would appear on the tape as a block sale (if you have
USING STOCK OPTION VOLUME AS AN INDICATOR
191
access to option time and sales, you would readily spot this fact). Onthe other hand, if most of the volume is in one put series, then aninstitution probably bought a block of puts to protect a holding in theunderlying stock. In either case, the trade, no matter how large it isand how many times it exceeds the average volume, has nothing todo with supposed corporate developments. Thus, this situationshould be rejected as not having any trading viability.Example: This situation is fairly common; ones like it occur almost everyday. Assume that total option volume in XYZ options was 1,385 contracts,while average option volume at the time was only 250 total contracts perday. Thus, this situation would show up on the initial computer runs. Suppose the stock had closed at 35 that day. Upon further inspection, however,this is how that volume broke down:OptionSep 35 callSep 30 putOct 40 call
Volume1,350 contracts23 contracts12 contracts
Thus, even though total volume of 1,385 contracts was significant inlight of the fact that average volume is only 250 contracts, it appears that ablock trade of 1,300 or more contracts took place. We say this is a blocktrade because there is only significant volume in the one series: the Sep 35call. In fact, if you subtract out the block trade, you often have a situationwhere option volume was below average that day.
If the volume is predominantly concentrated in one series but isnot identifiable as a block trade from the time and sales tape, it isprobably still not noteworthy. It is our feeling that if the public (whichincludes unknown inside traders) enters the marketplace and repeatedly buys one option series, the market makers end up selling themmost of the options. The market makers are, by definition, riskaverse. They attempt to make their money, if possible, by buying onthe bid and selling on the offer. If they can do that repeatedly and gohome “flat” every night, they would be quite satisfied. When thereis large demand in one series, the market makers cannot get flat;so they must hedge themselves by buying other options to partially
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THE PREDICTIVE POWER OF OPTIONS
offset the ones they are selling to the public. When they do this, theheavy option volume propagates itself out from the series that thespeculators are buying into other months and striking prices. Thistelltale “picture” is what we look for to define a true speculative situation. We show some examples of it shortly. For now, suffice it tosay that if nearly all the option volume is concentrated in one series,then there is very little chance (note, we do not say no chance) that atrue speculative position is at hand.There is always an exception to any rule, and the exception tothis concentration of volume screen may occur in a low-priced stock.If a stock is selling for less than $5 per share, it is possible that theonly striking price for its options is 5. Moreover, since you can fairlyassume that the stock has been declining for some time in order to beso low-priced, there is probably very little activity in the options. Insuch a case, there may be virtually no options offered in the midtermor long-term options. Thus, if “insiders” come in to buy options fromthe market makers, the market makers may have no place to go tobuy other options (they can always buy stock, of course; but it wouldbe in fragmented pieces, so it would be hard to spot). Thus, at theend of the day, almost all of the option volume might be concentrated in one series because that is the only series that is virtuallyavailable for trading.
Example: Suppose that XYZ is a $4 stock and that it has been depressed atthose levels for some time. The option exchange may even be consideringdelisting it. At one time there were striking prices of 15, 121⁄2, 10, and 71⁄2,but these are all now delisted because they have no open interest. Supposethat it is June and that the only options available for trading are the July 5s,August 5s, and October 5s.An insider wants to buy options in XYZ because he knows that thecompany is going to announce the signing of a large contract that will spurthe stock and make it rise in price. He first attempts to buy the July 5 calls,and the market makers sell him several hundred before they realize that thisis such a large buyer. Since this is a rather illiquid issue, there are no offersto speak of in either the Aug 5 calls or the Oct 5 calls. In fact, these samemarket makers won’t sell those calls, of course. Finally, they are forced tobuy stock as a hedge. The insider is probably buying stock by now, too,since they won’t sell him any more calls.
USING STOCK OPTION VOLUME AS AN INDICATOR
193
The end result is that we have a truly speculative situation; but at day’send, almost all of the option volume is concentrated in the one series—theJuly 5 calls. This is a stock that option volume watchers should want tobe in, but they will “screen” themselves out of it if they blindly apply thescreen that discards all situations in which the option volume is mostly inone series.
Another reason that there may be a large increase in volume isbecause a spread trade has been executed. There are option strategists who control rather large sums of money and who sometimesexecute large ratio spreads, vertical spreads, or combinations.Again, this type of trading has nothing to do with predicting forthcoming corporate announcements, and we must screen it out also.Thus, if almost all of the option volume is concentrated in justtwo series, especially if the two series have approximately equalvolume, then once again it is unlikely that a true speculative situation exists.
Example: Suppose XYZ is trading at 50, and we notice the followingoption activity at the end of a trading day:Average volume: 100 contractsToday’s volume:OptionFeb 50 callFeb 55 callMarch 50 callTotal volume:
Volume400 contracts425 contracts40 contracts865 contracts
On the surface, this looks like a huge option volume day, since 865contracts traded, as opposed to the average of a mere 100 contracts. However, most of the volume was in just two series—the Feb 50 and Feb 55calls—so it looks like this was a spread positioned by a nonspeculativetrader. We would discard this stock from further consideration as a tradingcandidate for that day.
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THE PREDICTIVE POWER OF OPTIONS
Another screening “rule” will also get rid of arbitrage situations.In conversion or reversal arbitrage, the arbitrageur takes a positionthat is equivalent to the underlying stock. This is the type of tradethat we discussed at length for some other applications, in Chapter3: buying the calls and selling the puts with the same terms is thesame as being long the stock. If a large arbitrage has taken place,then we will notice increased volume in just those two series—the putand the call with the same terms. If that constitutes most of theoption volume, then we can ignore the situation as having muchvalidity in terms of a true prognostication.Example: This time, suppose XYZ is trading at 40, with the followingoption volume:Average volume: 300 contractsToday’s volume:OptionMarch 45 callMarch 45 putMarch 40 callTotal volume:
Volume700 contracts700 contracts250 contracts1,450 contracts
Once again, we would probably discard this situation, as it appears thatthe volume in the March 45 calls and puts is part of an arbitrage (or a stockequivalent position, as described in Chapter 2).
Further screens can be applied. For example, a significant portionof the option volume will consist of at- or out-of-the-money options ifinsiders are doing the buying. Remember, they are attempting to useleverage, so they will normally attempt to buy the cheapest optionspossible. Thus, if you see that a large amount of the daily volumeis being contributed by deeply in-the-money options, then you canbe reasonably assured that this situation can be discarded.Example: Suppose XYZ is trading at 48 and option volume is heavy at1,000 contracts, as compared to the average volume of 250 contracts.However, the distribution of the option volume looks like this:
USING STOCK OPTION VOLUME AS AN INDICATOROptionOct 40 callSep 35 callSep 45 callSep 50 call
Price81⁄213411⁄2
195
Volume400 contracts400 contracts150 contracts50 contracts
Here, 80 percent of the volume is in options that are 8 or 13 points inthe-money. If the call buying were being done by speculators with some sortof inside information, they would want leverage. They would buy the Sep50 call and the Sep 45 call before they would buy the more expensive inthe-money calls.Admittedly, you would get some leverage by owning an 81⁄2 dollar callor a 13 dollar call as opposed to a 48 dollar stock, but that wouldn’t be yourfirst choice if you had inside information. Thus, we would have to concludethat this option volume is not predicting any corporate developments. It ismore likely that a quasi arbitrage or deeply in-the-money spread or coveredwrite was established by an institutional or arbitrage trader.
There is an exception to this screen also, and it involves putoptions. There is a strategy that some very large traders use in orderto get short stock in a fairly easy manner. Suppose that you had alarge amount of capital at your disposal and knew that a stock wasabout to get some bad news. Or perhaps it was already trading downsome, and you were having trouble getting an uptick to short thestock. No problem. If you could just buy a block of stock and simultaneously buy some in-the-money puts at parity, your problem wouldbe solved. Why? Because you could then just sell your stock, which islong, as sloppily and rapidly as you wanted in the open market. Thiswould leave you with just the long puts, which would of course beincreasing in value as you pummelled the stock. After you were doneselling your long stock, you would probably have scared other stockholders into selling, so they would be pushing the stock down fartherand increasing the value of your puts as well. Finally, you could exercise your puts to get short if you wanted to, but there wouldn’t reallybe any necessity for that.You might say that this all sounds well and good, but how couldthe trader just buy stock and buy puts in large size so easily? Theanswer is that an arbitrageur will take the other side of the trade,
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THE PREDICTIVE POWER OF OPTIONS
merely in order to earn interest on the credit balance generated byselling the stock and selling the puts. Eventually, when the speculative trader exercises the puts, the arbitrageur will be assigned and hisposition will disappear.The following example is in two parts. The first part shows thearbitrage; the second part shows how the situation looks to thetrader who is monitoring option volume.Example: Assume that it is early in July, XYZ is selling at 22, and aninsider knows bad earnings are on the way. He buys some out-ofthe-money puts, and a negative rumor circulates on the Street. A large, aggressive trader gets wind of the rumor and decides to capitalize on thesituation also.The large trader calls up an arbitrageur and asks if he would sell thestock (short) and sell the July 30 puts. The arbitrageur says that he will, subject to being able to borrow the stock. A check with the stock loan department shows that 60,000 shares of the stock are available for