Along with seemingly every other person on the planet I headed out last weekend to view the much anticipated Avengers movie. While I wasn’t excited enough to don my Captain America suit and shield, I did convince the wife to join me in the superhero revelry.  To the movie’s credit she enjoyed the storyline and more importantly the execution – and that’s saying something given that she’s eight months pregnant.

While my $20 “investment” turned out to be money well spent, I also came away from the blockbuster with a few trading related lessons in tow.  The overwhelming success of The Avengers is due in large part to the diversification embedded in the story.  Rather than only appealing to fans of the Hulk, Iron Man, or Thor, the movie targets all of them along with the remaining heroes simultaneously.   If the Captain America fans don’t show up, so what?  There are five other superheros beckoning their acolytes to the theaters to partake in the action.  The inherent diversification targets a much broader demographic than had the movie been centered around a single hero.

While there are many forms of diversification in the financial markets, some of which I’ve touched on here, here, and here, the one with perhaps the most relevance to the theme laid out by The Avengers is strategy diversification.    The tactic highlights the appeal of running multiple, somewhat uncorrelated strategies simultaneously.  Remember each strategy exhibits teeter-totter like performance, alternating between periods of out- and under-performance.  Mean reversion strategies shine when the market is range-bound, yet inflict losses when strong trending conditions emerge.  Trend-following strategies are essentially the opposite, yielding profits in trending environments and losses in range-bound markets.

Traders looking to improve the results of their market neutral strategies like condors and butterflies might consider running trending strategies alongside them.  This hybrid approach can often smooth out the month to month swings in PnL.  Think of it this way, when the condor is suffering due to a strong directional move in the market, the trending strategy should be shining.

Keep in mind one can’t simply cobble together two crappy strategies and expect magic to happen.  If both strategies yield profits independently then the combination of the two has a much better chance of succeeding.

The proper implementation of strategy diversification enhances one’s ability to generate profits in all market environments.  Though they won’t capture as many profits as a trader only employing trending strategies in a strong directional market, they also won’t incur near as many losses when mean reversion returns to rule the market.

This article was originally posted at InvestorPlace

Many neophyte option traders become unsuspecting victims to Gamma’s wily ways.  While these profit seekers are well-intentioned, their ignorance can prove costly particularly close to expiration.  Let’s just say the last few weeks leading up to expiration are when Gamma really takes hold and begins to play with your position for better or worse.  Before I continue with my carefully crafted explanation allow me to dispense a few obligatory facts.

Gamma is the rate of change of delta.

Gamma is the curvature of an option.

Gamma is highest for short-term, ATM options.

Long options have positive gamma, short options have negative gamma.

The second definition speaks to the general shape of an option’s risk graph.  Low gamma positions possess a flatter risk graph reflecting greater stability in the position.  High gamma positions boast a risk graph with decidedly more curvature reflecting heightened instability in the position.  Take the risk graph of the butterfly included below for example.  The butterfly is a delta neutral, negative gamma position engineered to profit from either the passage of time or a decline in implied volatility.  When structured with longer dated options the position is quite stable with losses accumulating slowly during adverse conditions.

Take note of the relative flatness of the blue line which illustrates the lower gamma risk when the position is 38 days to expiration.  Contrast this with the red line which reflects the same position a mere three days from expiration.  Gamma has grown and is now a dominant force influencing the outcome of the trade.  The position is increasingly unstable as revealed by the excessive curviness of the risk graph.  Even a small move in the wrong direction will result in giving back significant portions of the profit.

[Source:  MachTrader]

Managing a negative gamma position of this sort close to expiration can be a nerve wracking hire wire act.  While successfully traversing the wire promises outsized rewards, a slight misstep in either direction will prove quite painful.  Of course one can sidestep the tightrope altogether by exiting positions once gamma grows larger than one’s risk appetite can fully digest.

For related posts, readers can check out:
Public Enemy #1
Gamma Facts
Clash of the Greeks
Clash of the Greeks Part Deux

Views on volatility vary across the spectrum.  The lion’s share of long-biased investors quickly associate the “V” word with shocks to their emotional psyche and otherwise painful financial drawdowns.  Volatility has long since been lumped into a rather unsavory group of lepers and plagues that are altogether shunned by the masses.  Rather than flying solo, volatility has a well documented history of appearing hand in hand with bearish price action.  And therein lies the source of its widespread disdain.  Since it inevitably materializes in the midst of market corrections it’s associated with all sorts of hobgoblins that haunt the dreams of the everyday buy-and-holder.

Suppose we hijacked the ubiquitous Facebook “Like” button and linked it to the price movements of the S&P 500 Index.  Every day investors could select the button to express their affection toward current market movements.  No doubt the likability of Q1 2012 would have been through the roof.  In contrast to the docile bull that wooed participants last quarter, the past few weeks we’ve seen another less friendly character take control of the markets leaving many reaching for their dislike buttons.

On the other side of the aisle are a few addle-brained investors welcoming a resurgence in volatility.  I count myself among their ranks.  Such a welcoming attitude stems from two things.  First, every volatility rocket ship that has ever launched eventually succumbed to the inevitable pull of gravity.  While the CBOE Volatility Index and the slew of tradable products associated with it are rising in the short-term, their long-term return to Earth is all but assured.  On the backs of every volatility ramp lies a return to normalcy trade.  A trade which, by the way, can’t exist without the occasional deviations from the mean, the sporadic forays into the abnormal.

Second, with the last major upset to the volatility space having largely played itself out we’re in need of another lift.  I’m speaking in particular of the multi-month fall in the VIX, OVX, and GVZ that has taken place since the July-October correction last year.  For example, I track a couple short volatility strategies on USO and it was virtually impossible to find a trade I liked for May since volatility was so depressed.  The ongoing free-fall in oil along with a rise in OVX will do wonders for re-inflating premiums in USO.

Rest assured the market correction will sow the seeds for profitable short volatility strategies to be harvested in the aftermath of the turmoil.

I’ve received a couple inquiries regarding my absence in the blogosphere of late and wanted to offer up a brief update. I’m sitting for the level II CMT exam next Saturday so my time has been spent with my nose in a score of Technical Analysis tomes in an attempt to internalize the finer nuances of Point and Figure, Elliot Wave, Cycles,  Inter-market Analysis and the like.

Needless to say my blogging will continue to be sparse, if not non-existent for the next week and a half.  Following my all but assured passage of the exam I’ll return to unleash a flurry of dope blog posts.

Pretty price patterns can be hypnotizing.  Their subtle sexiness can lure you in and convince even the skeptical spectator that the elusive “sure thing” has been discovered.  Unfortunately, the poor saps that fall into this trap usually end up having their hearts ripped out for confusing a high probability setup with an infallible one.

And, let’s be honest.  The recent topping action in bond prices was virtually textbook -  (1) clean rounded top, (2) a big breakdown, and (3) a bearish retracement to prior support which became resistance.  Up until this week all was going according to the bear’s plan – a plan, by the way, that my bear call spreads had a vested interest in seeing succeed.  But, alas, such was not meant to be.  The strongly entrenched inverse correlation between stocks and bonds entered the mix and made a mess of things.  The recent job’s number free-fall in stock land sent investors scurrying into the safety of treasuries thereby thwarting the beautiful bearish trend reversal.

I suppose one key takeaway is that trader’s mustn’t look at bonds in isolation.  They are one piece in a much larger integrated puzzle making a lot of their movement a mere side affect to what is happening elsewhere. One thing is for sure, it will be difficult to knock bonds from their lofty heights if  equities are entering some prolonged correction.

I still think longer term bearish ideas look appealing on TLT. In the short-term, however, I’ve been ousted from the bear train and am waiting patiently at the station for another alluring entry.

Source:  MachTrader

For related posts, readers can check out:
Fade the Bond Pop
Bonds. Short Bonds.
Bond Yield Beatdown

It’s not uncommon for discussions on the option Greeks to border on the mundane. A discourse replete with facts and figures runs the risk of becoming forgetful to the reader. Sometimes the behavior of the ever-important Greeks are best illustrated with a story.  Consider the following parable of the Theta Thief.

Though the lifespan of an option contract varies from one week to multiple years, its death date is known from inception. Following its creation by the powers that be and its listing on an options exchange, a clock begins to tick marking the passage of time until the inevitable end.

Though each option possesses a set amount of extrinsic value (sometimes called time value) when it first comes into being, a sneaky little thief called Theta relentlessly hounds the option and steals a modicum of extrinsic value every day.

At first Theta is a bit timid, only looking to steal insignificant amounts of value from the option. With months to expiration, Theta has plenty of time to pilfer from the extrinsic value stash. Over time, however, Theta’s boldness builds.  With each passing day, he brazenly withdraws increasing amounts of money from the option’s dwindling supply of extrinsic value. The rate of his thievery increases at an exponential rate.

Interestingly, Theta doesn’t steal from every option at the same pace, even if they have the same expiration date. Because at-the-money options are endowed with more extrinsic value than any other strike price, they are the most susceptible to Theta’s predatory antics.

To largely inoculate themselves against Theta’s thievery, traders typically look to buy longer-dated options.

While Theta is the foe of option buyers, he acts as the friend to option sellers. As a matter of fact, all the money he is removing from the option’s value is going directly into the pocket of the option seller.

This, of course, explains in part the appeal for option-selling strategies such as covered calls and naked puts.  They enable you to dispatch the sneaky thief to incrementally steal extrinsic value and deliver it directly to your brokerage account. Traders looking to maximize Theta’s pirating will look to sell shorter-dated options.

Whether you’re venturing into the options market with a penchant for speculation or risk aversion, don’t forget the role the Theta Thief will play throughout the duration of your trade.

This post was originally published at InvestorPlace.

For related posts, readers can check out:
The Disproportionate Distribution of Theta Burn
The Wrench in the Theta Clock
Expiration Temptation

Painting with a broad brush maybe appropriate when discussing things of a homogeneous nature like, say, all the black honey badgers in Africa.  When it comes to a heterogeneous mishmash of items, however, wielding the broad brush can lead to a number of erroneous characterizations.

Today’s thoughts are inspired in part by a recent comment I came across that labeled the options market as an arena for “high risk gamblers” that should be otherwise off-limits for those engaged in “sound investment planning”.  While such an assertion may be a fitting description of a small sub-set of speculative option trades, it fails to account for the broad swath of strategies that are used by ultra conservative investors hell-bent on risk avoidance.

A more accurate description of the options arena is a marketplace where traders, often possessing diametrically opposite investment objectives, come together to play.  Though participants can enter with opposing goals in mind, they can all depart knowing their respective missions have been accomplished.

It’s interesting that no-one would depict a 70-year old couple purchasing an insurance policy protecting against floods and fire as degenerate gamblers, yet if the same couple enters the options sandbox to acquire insurance of a similar sort for their stock portfolios they stand to be branded as risk loving speculators.

As if often the case with aspersions cast by those who irresponsibly or ignorantly yield the broad brush, their rantings reveal more about themselves than the targets of their derision.

For related posts, readers can check out:
Risk Reduction – Pick a Door
Step into a New Dimension

Recent action in AMZN provides a prime example of the risk-reward payoff for the notoriously difficult long straddle play.  In an attempt to attract others to their ranks, straddle acolytes possess a number of seductive, yet slightly misleading, tag lines.  Take the following for instance:

“You win whether the stock moves up or down!”

The trouble with the assertion is that it oversimplifies how the strategy accumulates profits.  Such a mischaracterization leads the well intentioned masses into thinking the straddle sits close to a sure thing when in reality it resides in a different hemisphere altogether.

To those otherwise unfamiliar with the main character in our tale, the straddle consists of simultaneously purchasing an at-the-money call and an at-the-money put that expire in the same expiration month.  The position is considered a bi-directional, long volatility bet.  Contrary to popular belief it does not win whether the stock moves up or down.  Rather, it wins if the stock moves up or down more than is expected.  Sadly, the options market isn’t run by dimwitted ignoramuses.  It’s an efficient monster with a voracious appetite for any free lunches that might be lying around.  With regards to straddles this means they will often be accurately priced making their purchase anything but a slam dunk.

Purchasing a straddle then isn’t so much a bet that the stock is going to rise or fall a large amount, but rather that the stock is going to rise or fall more than the options are already pricing in.  It’s the expression of an opinion that the marketplace has it wrong.  Unfortunately consistently identifying the mispricing of straddles is easier said than done.  The difficulty of such a task explains in part why long straddles aren’t as frequently used as other strategies such as vertical spreads.

In the end, they should be used sparingly in the somewhat rare situations where the efficiency monster has left a free lunch or two lying around.  While there aren’t any guarantees, your straddle success can be increased by looking for scenarios where implied volatility is cheap and the underlying stock appears poised for a strong move.  The recent symmetrical triangle in AMZN coupled with its multi-year low in implied volatility represented the ideal scenario for straddle buys.  Its breakout and subsequent pop in implied volatility has shown the potential reward available to those prescient enough to jump in just prior to the breakout.

Source:  MachTrader

This article was originally posted at InvestorPlace.

The massive rounded top in bonds that has been six months in the making finally cracked two weeks ago.  Following the latest Fed announcement on March 13, a massive capital shift ensued as money flowed out of the bond market and into the welcoming arms of equities. The trading volume that accompanied the two-day plunge was the highest seen in the iShares Barclays 20+ Year Treasury Fund (TLT) since September of last year.

Given that major support has been broken and the 50-day moving average (blue line in chart) is now sloping downward, one could make the case that a longer-term trend change is afoot. If indeed more downside is in the offing, then last week’s three-day rise in bonds is likely a sucker’s rally that should be sold.

As outlined in Bonds and the Financial Puzzle, a full-fledged trend reversal in bond prices should bode well for stocks overall.   Provided of course the strong inverse relationship between these two asset classes remains in force.

Source:  MachTrader

[Disclaimer] Short TLT

The CBOE Futures Exchange (CFE) recently announced the open interest in VIX futures reached a new all-time high at 282,314 contracts on March 5.  The besting of the previous record set a short four days earlier on March 1 is yet one more sign of the increasing interest of the investing masses for the CBOE Volatility Index and its related trading products.

While it is easy to conclude the uptick in activity reveals a rise in popularity, it is difficult to determine what implications, if any, this may hold for the future direction of the VIX Index.  While some may contend this is a contrarian indication that the VIX is close to a bottom, such an argument is tenuous at best. Rather than concocting some type of open interest based theory to support a bullish or bearish outlook on the fear gauge, traders would be better served by focusing on tried and true measures that have been quite reliable in forecasting VIX movement such as the price trend of the S&P 500 Index and recent realized volatility.

Don’t overlook the simple inverse relationship between the price movement of the SPX and that of the VIX Index (i.e. SPX down, VIX up).  Provided the SPX uptrend continues powering higher I see little reason in attempting overly bullish bets on the VIX.  The VIX will not magically reverse its six-month downtrend in the midst of a strong equities market. When the SPX uptrend begins to falter, VIX bulls will have a much more compelling argument.

Yet another indicator far superior to VIX futures open interest when playing the VIX forecast game is recent realized volatility in the SPX as measured by 10 day historical volatility.  Remember, the VIX reflects market expectations for how volatile the SPX will be over the next thirty days.  Determining how much the market is actually moving in the here and now and comparing it to expectations for future volatility can give you a good idea as to whether or not things seem out of whack.

Over the past six weeks, 10 day historical volatility on the SPX has been languishing around 10%.  Absent any type of appreciable increase in this reading it makes little sense to argue the VIX should surge from current levels.

Here’s the bottom line: With the SPX still firmly entrenched in an uptrend and realized volatility in snooze mode, I would remain reticent to making bullish VIX bets.