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Market Measures

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Volatility & Time

Market Measures

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

Tony: Thomas we're back, my friend, Market Measures. E-Mini S&P is up $1.15, NASDAQ up $2.75, Russell up $1.20, Dow down $0.05.

Tom: It’s okay. You know what, it’s better to get him going from, its almost …

Tony: It’s better to have loved and lost than never to have loved at all.

Tom: Some like that, I bet.

Tony: Is that, so it’s like I don't believe that that’s.

Tom: Some like that. But, yeah, it’s better to get them going. I just put a two off just to see if we can get to some action in here.

Tony: Some action.

Tom: Just to put some on the board.

Tony: Action, action ACT, [inaudible 00:00:47] NASDAQ, right.

Tom: I’m just going to get some S&P and some NASDAQ action going because I think you just …

Tony: 37.72 even.

Tom: It should get something going, right. All right, let’s do this.

Tony: How many S&Ps have had a good 10, 11 point range [inaudible 00:01:09] this morning, but it feels like nothing, right, because it’s overnight.

Tom: It does feel like nothing [inaudible 00:01:14] if they dropped them, I don't know, let’s see what happens.

Tony: [inaudible 00:01:18] feel like little some.

Tom: Little some, some. I don't know. I think you just got to keep someone [inaudible 00:01:25] doesn’t work.

Tony: Got it.

Tom: Are you ready?

Tony: Yes, sir.

Tom: Really interesting market measure today. In fact one that I think is, ones going to open a few eyes.

Tony: Beautiful. Let’s do it.

Tom: The Theta/Vega relationship, this is the relationship between time and volatility. I’m sorry, the relationship between time and volatility plays a critical role in price of options. Essentially it allows us to determine how much data we are collecting relative to the amount of volatility or Vega risk we are taking on.

Again, we are calling this today the Theta/Vega relationship. It’s the relationship between time and volatility, and many of you’ve wrote into us to ask questions about that, just, “Hey, listen, it’s just we are covering one more base, we are just building up intellectual property.”

Again, the purpose here is to allow us to determine how much data we are collecting relative to the amount of risk we are taking and how to put some context around that. Never covered this before, so I think the stuff we are doing today you are going to like it. But Theta/Vega relationship can be calculated as a ratio between the two. The higher the ratio the greater amount of Theta we are obtaining relative to the volatility risk. A higher ratio would also provide optimal scenarios for selling premium.

That makes sense, right.

Tony: Sure, it does.

Tom: The higher the ratio, the greater amount of Theta we are collecting relative to the amount of volatility risk that we are taking, so a higher ratio also provide the optimal scenarios for selling premium. To observe the nature of this ratio, and again I don’t know if I’ve ever seen anybody cover anything like this, we’ve conducted the following study: Spiders, Qs and GLD. 2009 to Present, 195 occurrences, the guys went through.

As you can see, we are ramping up our research dramatically in just the last couple of weeks because we were able to ramp-up our team. We’ve entered one standard deviation strangle on the first day of the month closest to 45 days to expiration and 75 days to expiration. Then we calculated the initial Theta/Vega ratio because what we are doing is we are taking the greatest amount, we are taking all the emails we receive, we are queuing them up and we are basically sorting by questions than saying, “Hey, this is what most people ask.”

So to see how we calculate the ratio, consider the following table where a one standard deviation strangle was placed in periods of high volatility and low volatility. Here is the SPY with IV extremes, this is a one standard deviation strangle. As you can see when the IV rank is four, the Theta/Vega ratio is 0.24; when the IV rank is 81, the Theta/Vega ratio is 68.

Tony: And you want a higher?

Tom: Yes, and you want a higher ratio.

Tony: Ratio.

Tom: Now in with 75 days to go to expiration, you can see how it’s also muted a little bit, but again with the IV rank of four, the Theta/Vega ratio is … and that’s just getting filled on S&Ps, the Theta/Vega ratio is 0.14, and with 81 days to go it’s 0.36. Again, you want higher implied volatility.

Tony: Correct.

Tom: Right. That’s it.

Tony: You can see here the ratio, it shows you that the 45 days seems to work better than the 75 day on those ratios.

Tom: Yeah, the 45 day works better, and the 45 day it’s the difference is, it’s actually more pronounced too. It’s not that the 75 day doesn’t work especially for high view or whatever it is, but the 45 day, there is a reason that’s our sweet spot, and I would just stick with it.

Tony: Now we’ll look at the average Theta/Vega ratio for one standard deviation strangle placed in different IV environments over the past five years. First we are going to look at the spiders, and we are going to look at low IV and 45 days to go and 75 days to go, mid IV and high IV. You can see the dramatic difference of why high implied volatility is so critical to the success of our trading, we just haven’t had it.

Now again, you are saying, the most, the simplest thing to say is, “Well, why don’t we do just the other side?” Because that doesn’t work, because you can’t inventory it.

Tom: Correct. I know everybody says we’ll just do the other side but it doesn’t work, because again it can’t be inventory, period. All right, next we are going to look at the Qs. As you can see here, a little bit different. And in the Qs, 45 days, 75 days and the numbers, it’s the one where the numbers aren’t nearly as serious, and I don’t know why, but just the way they came out, but 21, 26 and 22, and then with 75 days to go, a little bit more perhaps. It maybe because the Q implied volatility as form.

Tony: [inaudible 00:06:31].

Tom: Faster than anybody could imagine.

Tony: And stayed lower, right.

Tom: And stayed lower.

Tony: [inaudible 00:06:35] has bounced around a relative to the Qs a little bit more.

Tom: Correct. Here is GLD, this looks more in line with everything else that GLD is cold, 18, 26, 38. Again, much more in line with everything else we’ve looked at. And then we go to our wrap-up upside, which is our portfolio. We look at 45 days to go to expiration and 75 days to go to expiration, and you can see the Theta/Vega relationship as measured, the higher number is better. You can see right here that with 45 days to go, you want to sell high IV, and if you can’t you got to sell mid-range IV.

Whether it’s 45 days or 75 days, you can see how that relationship just turns. I shouldn’t say it turns negative because we don’t have P&L numbers on here, but it turns sour. Again, these are the answers to the questions that we started with before. This is why it’s so difficult to make money, even though you can be right, but it’s so difficult to make money when you don’t have the support.

Let me go back for a second. Oops, yes. The basis behind today is, Market Measure, is you can see it on this slide here. What we’ve done is we’ve essentially said in periods of IV rank of four or 81, the Theta/Vega ratio is 0.24 with IV rank low, and 0.68 with IV rank high. And then we did it with 45 days and 75 days to go to expiration. You can see the optimal times for doing your thing.

Tony: Correct.

Tom: Again, this is just, you bank this and lecture, this goes into the encyclopedia. This is just another reason why when you are looking at your volatility risk relative to your time value decay, you can assess your risk reward and your pot odds.

When you sit there and you look at a four, an IV rank of four, like you looked at UNG this morning, which should have an IV rank of four. And you sit there, you say, “I think I want to sell a strangle in here, no matter what.” You can assess the fact that your Theta/Vega ratio, your volatility risk relative to the amount of money you are going to collect is going to be at an extreme low number, which means if you’re wrong; if you are right, you’ll still make a little bit of money.

Tony: Sure.

Tom: But the statistical chance of making money versus the risk you are taking isn’t that good. A poker player will say something like, “Well, I’ve got 2.5 times in the pot,” or “I’ve got one and a half times in the pot.” Some number they’ll come up with, with some way to rationalize it.

Tony: I’m going to stay in this hand a little bit longer because of that.

Tom: But traders don’t do that. Traders don’t do that. They’ll look at IV rank of four and they’ll say, I just think, a natural guess doesn’t go anywhere.

Tony: Right.

Tom: So I’ll sell this without thinking that, “Hey, you know what, that Theta/Vega ratio, that’s really bad.” We are going to add this kind of a tool to Dow. Its coming to a Dow platform near you, so that you can look at real simple and put some, assess some number or quickly look at some number, so that you can look at both IV and Theta/Vega ratio, and then quickly assess, “Okay, well, this is why it makes no sense at all,” or “This is why it makes sense.”

Tony: Right, now that $0.36 there, that’s $0.36 of Theta for every dollar of Vega risk.

Tom: That’s correct. Just imagine down the road when we start to put all the efficiency numbers inside of a software platform, along with Theta Vega ratios, you aren’t going to have to do very much at all.

Tony: You just scan the number.

Tom: That's right.

Tony: [crosstalk 00:10:34].

Tom: And figure out how you want to diversify your portfolio and how many occurrences you want to have. So anybody thinks, “Hey, this stuff is just like, it’s overwhelming,” it’s actually not. It’s actually stuff that, I think it will all start to make even more sense.

Tony: Sure.

Tom: As we put it inside the technology, so that it becomes second nature.

Tony: Agreed.

Tom: Anyway, this was a great study I think the guys did. I think this is, we make it short and sweet because everything should have a two, five, 10, maximum 12 minute timeframe.

Tony: Correct.

Tom: When you do stuff to the …

Tony: To the segment.

Tom: When you do stuff live on the air, everything should be 10 to 12 minutes.

Tony: We are going to keep everybody’s attention.

Tom: We’ll keep attention. So this is probably one of the strongest 10 to 12 minutes or eight to nine minutes of content you are going to see and just bank it, put it and book it.

Tony: Got it.

Tom: But all of its archived, it will be up in less than an hour.

Tony: Very good, sir.

Tom: Let’s just take a look at the S&Ps, S&Ps are trading for $129.75, up a $1.50, we sold them at $1.30.

Tony: [crosstalk 00:11:45] 1930, we sold them quarter higher than where ...

Tom: NASDAQ Futures we sold them at two even, they are two half. I don’t, these are little mini scalps, hopefully it doesn’t turn into anything disastrous to the upside, and hopefully we can make a couple of bucks to the downside and, I don't know. That’s all I see right now.

Tony: But you got basically a slightly higher to unchanged market in just about everything. I’m looking at gold, I’m looking at silver, I’m looking at volatility, I’m looking at the [inaudible 00:12:14] S&Ps. It’s kind of Friday is closed, right.

Tom: Price lines of $12, I don't get that.

Tony: That’s had a turnaround.

Tom: I don't get that at all. I think I didn’t do anything there.

Tony: [inaudible 00:12:22] is up $5.

Tom: GDX is only up $0.02, [inaudible 00:12:28] won’t be filled in our spread, and who knows. Listen, I think at this point we know we are too deep, just trade them if they are there, and we are just using the delta and capital efficiency of Futures right now, just because I’m not [inaudible 00:12:44] there is a lot more to do or sell, but we’ll spend some time looking. Like people send us emails all the time, they say, “Hey, take a look at this, take a look at this, take a look at this.” We will, we do.

Tony: Of course. And then the other side of the coin you’ve got Google down $6 in change and Baidu down about $2.50.

Tom: Baidu can go to …

Tony: LinkedIn down $1.82, I’m just mentioning LinkedIn.

Tom: There is no number Baidu can go to, for me, there is absolutely no number. But if China rolls over, what’s FXI doing?

Tony: It’s up [small 00:13:12] before, hold on.

Tom: Because I thought China was rolling.

Tony: Down $0.12 now.

Tom: If China can rollover me, the rest of the world can.

Tony: We’ll be back in 90 seconds, we got … what else you got next? You are listening to tastytrade LIVE.

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